The Dot-Com BubbleIs Reconsidered -- And Maybe RelivedNovember 8, 2006; Page B1The traditional history of the dot-com bubble has been told many times: Too many companies rushed into the market in defiance of all known business fundamentals, and when the crash came, all but a tiny fraction of them just as quickly imploded and went away.

That received wisdom, though, is now getting a going-over by economists, business historians and others, some of whom are coming to new conclusions about what precisely went wrong during the bubble years, normally dated from the Netscape IPO in August 1995 to March 2000, when Nasdaq peaked at above 5100.

A recent paper suggests that rather than having too many entrants, the period of the Web bubble may have had to few; at least, too few of the right kind. And while most people recall the colossal flops of the period (Webvan, pets.com, etoys and the rest) the survival rates of the era's companies turns out to be on a par, if not slightly higher, than those in several other major industries in their formative years.

The paper is being published in a coming issue of the Journal of Financial Economics. As noteworthy as the findings are, even more interesting is the process that led to them. The work is an outgrowth of the Business Plan Archive at the University of Maryland. Its goal is to become a kind of Smithsonian Institution of the Internet bubble, saving for posterity every business plan, PowerPoint presentation and venture-capital term sheet -- the more frothy and half-baked, the better -- that it can get its hands on.

David A. Kirsch, a professor of management at the university's business school and one of the authors of the study, said it relied on a thorough examination of one particular treasure trove at the archive: every business plan, roughly 1,100 in all, submitted during the period to an East Coast venture firm.

The VC office later closed and donated the papers to the archive on the condition it remain anonymous. Prof. Kirsch said that while the office would be considered second tier when compared with the famous names in Silicon Valley's Sand Hill Road, the 1,100 firms he studied were representative of all of the companies started during the period.

Looking through those business plans, and contemporary press accounts, the study identifies a defining business strategy of the bubble era: Get Big Fast. A business was supposed to grow as quickly as possible because the first successful entrant in a category could keep out challengers. If a company was able to successfully get big, it could use that position to later finesse other questions, such as how it might one day actually make money.

Belief in this "first mover advantage" is today tempered by a new awareness of the risks of being the first out of the chute. Back then, though, VCs used Get Big Fast as their basic investing strategy, despite the absence of any evidence that it worked. By the spring of 2000, however, the world was beginning to wake up to the fact that it didn't work. The crash followed soon thereafter.

The study suggests, though, that the dimensions of that crash might be misunderstood. Nearly half of the companies they studied were still in business in 2004. Prof. Kirsch says that most people believe just a few percent made it through.

The study found that the attrition rate for dot-com companies was roughly 20% a year, which is no different from what occurred during many other industries, such as automobiles, during their early boom periods.

Most of these survivors, though, aren't the titans like Amazon or eBay, but much smaller efforts such as wrestlinggear.com, which sells equipment to high-school and college wrestlers, what Prof. Kirsch called precisely the sort of demanding niche market for which Web shopping was invented.

The fact that so many dot-com companies survived suggests that even more could have started. But that didn't happen, says the study. Investors following conventional wisdom of the day were interested only in companies that could dominate an entire industry. In looking for these, they ignored smaller niche opportunities that had the potential to become modest but profitable enterprises.

"It turns out there were lots of nooks and crannies for entrepreneurial action," says Prof. Kirsch. "But those nooks and crannies might have been $5 million or $10 million businesses -- well worth doing, though not necessarily for VCs."

The paper's other authors were Brent Goldfarb, a University of Maryland economist, and David A. Miller, of UC San Diego.

While they didn't deal with the current Internet bubble involving "Web 2.0" companies, it's clear that a variation on Get Big Fast is alive and well today, just a few years later.

Companies like Interactive, eBay and Google are spending hundred of millions, often billions, on start-ups such as MySpace, Skype and YouTube, which have developed a commanding market presence but without actually making money. Some of the explanations for these purchases have a certain logic; others seem like dot-com d?j? vu.

It will take awhile to know whether things will turn out differently this time. But bubbles always have happy endings, don't they?

The dismal scienceMaster of the IslandWhich country is the best colonizer?By Joel WaldfogelPosted Thursday, Oct. 19, 2006, at 3:09 PM ET

A generation ago, Christopher Columbus was a hero. No longer. Even my preteen kids can tell you that Columbus' followers brought disease and death to many New World natives. But as the forerunner of European colonization, can Columbus also claim to have ushered in an era of higher standards of living?One of the deep questions in economics is why some countries are rich and others are poor. It is widely believed that institutions such as clear and enforceable property rights are important to economic growth. Still, debates rage: Do culture, history, government, education, temperature, natural resources, cosmic rays make the difference? The reason it's hard to resolve this question is that we have no controlled experiments comparing otherwise similar places with different sets of legal and economic institutions. In new research, James Feyrer and Bruce Sacerdote, both of Dartmouth College, consider the effect of a particular aspect of history?the length of European colonization?on the current standard of living of a group of 80 tiny, isolated islands that have not previously been used in cross-country comparisons. Their question: Are the islands that experienced European colonization for a longer period of time richer today?

Imagine the ideal experiment for measuring the role of European colonization on economic growth. You would take a bunch of Europeans, set them down on different isolated islands for different lengths of time, wait a few hundred years, and then check to see whether the islands fertilized with Europeans for longer periods had become more prosperous. The insight of Feyrer and Sacerdote's paper is that the colonization that followed European voyages of discovery to the Pacific created just this experiment.

Mitiaro, Pohnpei, and Aitutaki?these are small islands in the Pacific that were colonized by European explorers at different times. They, and 77 other islands in the Atlantic, Pacific, and elsewhere, constitute the data the authors use in their study. Scholars who have made cross-country comparisons before have ignored these islands. Europeans "discovered" some of these places by accident. Pitcairn Island was colonized when the crew of the HMS Bounty staged a mutiny after an arduous trip to Tahiti under Capt. William Bligh. Explorers encountered Penrhyn, in the Cook Islands, after storms wrecked their vessels on its shores.

Feyrer and Sacedote's key findings are that the longer one of the islands spent as a colony, the higher its present-day living standards and the lower its infant mortality rate. Each additional century of European colonization is associated with a 40 percent boost in income today and a reduction in infant mortality of 2.6 deaths per 1,000 births.

By itself, the relationship between longer colonization and higher living standards could arise either because European contact raised living standards or because European explorers colonized the most promising islands first. The authors cleverly reject the latter possibility by noting that the sailing of the day relied on wind, which meant that islands located where wind is weak were "less likely to be discovered, revisited, and colonized by Europeans." Thus, wind conditions, rather than island promise, determined which islands were colonized first, and so which islands remained as colonies longer. The relationship between colonial duration and wealth reflects the effect of colonization on material living standards, rather than the other way around.

So, what did the Europeans do right? The authors conclude that there's no simple answer. The most plausible mechanisms include trade, education, and democratic government. When the study directly measures these factors, some of them help to explain income differences among islands?for example, the places that traded only basic agricultural products in colonial times now have lower living standards. But even after accounting for these concrete determinants, longer European colonization has some extra pro-growth effect. Exposure to European colonizers, it appears, benefits living standards for reasons apart from the direct effects of government, education, and markets.

To be sure, Europeans have not always been benevolent masters. Before the Enlightenment, they tended to view natives as savages who were better off dead than not baptized. After about 1700, however, attitudes began to change. While 16th-century explorers like Magellan set out to spread Christianity as well as make money, later voyages, like those of English Capt. James Cook between 1768 and 1779, had more explicitly scientific aims. The experience of island colonies reflects the difference. When the authors divide the islands into those that were colonized in the centuries before 1700 and those that were colonized after, current island income is 64 percent higher per century for the post-Enlightenment group but only 11 percent higher per century for the pre-Enlightenment one. And, no, the effects don't appear to stem from the replacement of decimated low-income native populations with higher-income Europeans.

The authors also compare the experiences of separate Pacific islands with eight different colonizers: the United States, Britain, Spain, the Netherlands, Portugal, Japan, Germany, and France.* Their verdict is that the islands that are best off, in terms of income growth, are the ones that were colonized by the United States?as in Guam and Puerto Rico. Next best is time spent as a Dutch, British, or French colony. At the bottom are the countries colonized by the Spanish and especially the Portuguese.

There is no disputing that thousands died in the wake of European explorers' discovery of the New World. That's bad. But we can still give a small cheer for Columbus, because European colonization brought riches in its wake.

Correction, Oct. 23, 2006: The original sentence included Denmark among the eight colonizers that the study compares. It should have included the Netherlands instead. (Return to the corrected sentence.)

Joel Waldfogel is the Ehrenkranz family professor of business and public policy at the Wharton School of the University of Pennsylvania.

The charts with this piece don't print here, but still worth the read.===============

From Ritholtz..The Return of M3in Data Analysis | Economy | Federal Reserve Last year, we lamented the passing of M3 reporting. This broadest of money supply measures had shown a discomforting increase in liquidity, far greater than what M2 was revealing.

At the time of the M3 announcement, we suspected the Fed was attempting to cover their tracks, disguising an ongoing increase in money supply and an unstated "easing" in Fed bias. Since that time, we have learned: the Treasury Department was also adding liquidity -- a duty they have assumed, in part, in addition to the same performed by the Fed. Indeed, based on the credit growth data Doug Noland published last month ( October Credit Review), it appears that the Fed has ? despite increasing interest rates ? actually eased over the last two years.

In light of all this excess cash sloshing around, we wondered what M3 might look like if it were still being reported.

Wonder no more: We have located 2 separate sources for the reporting of M3. The first is Nowandfutures.com. As this article discusses, recreating M3 from publicly available data was relatively easy to do (to 5 nines accuracy).

As the chart below shows, M3 is alive and well and growing significantly. (A longer term M3 chart can be found here).

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M3 January 2003 to presentclick for larger graph

Source: Now and Future

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Why is this significant? Well, M3 is growing quite rapidly, with the annual rate of change now over 10%. Prior to the announcement of M3's demise, its growth was in the range of 3 - 7%.

Anytime a government agency stops reporting about their goings on, it should raise a few eyebrows. Now we see what happened once the reporting of M3 was killed -- that measure of money supply spiked much higher -- a rate of change that's even greater than 10%+.

Funny how we alter our behavior when we think no one is watching what we are doing, isn't it?

What makes this particularly egregious is that the broadest measure of Money Supply that is still "officially" reported -- M2 -- and its been flat for 2006 (as my pal LK likes to remind me all the time).

Have a look at this chart:

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M2 versus M3 Money Supply Growth

Source: Shadow Government Statistics

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This is a classic case of "ignore what they are saying, because what they are doing is speaking so loud:" While the Federal Reserve has been reporting rather flat money supply growth in M2 ( blue line), in reality they have been dramatically increasing the cash (red and blue line) available for speculation.

Hence, that sloshing sound you heard. They have been providing the fuel for the rally, the huge M&A activity, the explosion in derivatives -- even the eye popping Art auctions are part of the shift from cash to hard assets. It is just suupply and demand -- print lots of lots of anything, and that thing becomes increasingly devalued. It works the same for cash as it did for Beanie Babies.

Its not just the increase in Money Supply that should be concerning to investors -- its the misdirection about it. If Money Supply matters so little, as Fed Chair Bernanke has been out explaining to anyone who will listen, why pray tell has the Fed been working those printing presses overtime?

Given M3 increases, its no wonder the European Central Bankers laughed at the suggestion.

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William McChesney Martin, Jr., Fed Chair from April 2, 1951 to January 31, 1970, famously described the role of Central Banks thusly: "The job of the Federal Reserve is to take away the punch bowl just when the party starts getting interesting."

It seems the present Fed is not only NOT taking the punch bowl away -- they are spiking it with alcohol. I am not looking forward to the hangover that's to follow . . .

"The movement that built the first national democracy was not triggered by an uprising of the masses; nor was it led by intellectual theorists. It was led by entrepreneurial men of means...In fact, starting a business develops precisely the traits that make democracy work. It requires independence, much effort, and self-discipline--but also the ability to work with others and the recognition that you can only succeed by serving the needs of others." -- Carl J. Schramm, The Entrepreneurial Imperative, p. 161

This is the first of three essays on the theme of the significance of entrepreneurship in America. This essay looks at "American exceptionalism" with respect to entrepreneurship. The next essay will look at entrepreneurship and income inequality. The final essay will look at education and entrepreneurship.

Carl Schramm's thesis is that entrepreneurialism is as important to American culture as it is to our economic vibrancy. By the same token, in order to live in a congenial world, it is as important for the U.S. to export entrepreneurialism as it is to export democracy.

Compared to the United States, other developed countries, particularly in Continental Europe, put up more regulatory impediments to entrepreneurs, particularly the important subset of entrepreneurs that I will define below as change agents. In underdeveloped countries, regulatory impediments are compounded by crime and corruption, creating an environment even less conducive to entrepreneurship.

Defining Terms

The term "entrepreneur" has at least two connotations. The term could describe someone who launches a new enterprise. Alternatively, an entrepreneur could be defined as someone whose income is at risk in a business.

My preference is to require that a person satisfy both connotations in order to be called an entrepreneur. That is, my definition of an entrepreneur is someone who both launches a new enterprise and bears considerable risk and accountability relative to its success. To my way of thinking, an innovator who develops a new product within the safe confines of a university, a government agency, or an existing corporation is an intrepreneur, not an entrepreneur. Someone who has a very high degree of risk and accountability but who did not launch the business is a hired executive, not an entrepreneur.

An important subset of entrepreneurs (and of intrapreneurs) might be termed change agents. A change agent's new enterprise defies conventional wisdom and habits in some important way. Famous entrepreneurs, from Thomas Edison to Steven Jobs, are change agents. Change agents encounter resistance from people who are unwilling or unable to see the benefits of innovation, which explains why personal charisma and salesmanship can be important to their success.

Most entrepreneurs are not change agents. More typically, entrepreneurs own individual franchises, small retail stores, and just about anything else that you would find in a typical strip mall. These businesses require dedication, risk tolerance, and hard work to operate, but they do not depend on or attract change agents to launch them.

Amar Bhide, in his classic treatise, uses the term "promising start-ups" to describe businesses started by change agents and the term "marginal businesses" to describe the more routine entrepreneurial efforts. This terminological exercise may seem tiresome, but otherwise one can slip into using the term "entrepreneur" in multiple ways, depending on context.

Continental Europe

Edmund Phelps is the 2006 winner of the Nobel Prize in economics. Shortly after his award was announced, Phelps published an essay on how capitalism in the United States differs from the system in Continental Europe. Phelps wrote,

There are two economic systems in the West. Several nations -- including the U.S., Canada and the U.K. -- have a private-ownership system marked by great openness to the implementation of new commercial ideas coming from entrepreneurs, and by a pluralism of views among the financiers who select the ideas to nurture by providing the capital and incentives necessary for their development. Although much innovation comes from established companies, as in pharmaceuticals, much comes from start-ups, particularly the most novel innovations...

The other system -- in Western Continental Europe -- though also based on private ownership, has been modified by the introduction of institutions aimed at protecting the interests of "stakeholders" and "social partners." The system's institutions include big employer confederations, big unions and monopolistic banks.

In Continental Europe, large banks control the bulk of investment. The United States has a more vibrant stock market, many more banks, venture capital firms, and other financial channels.

In Continental Europe, large established firms have access to funds from the large banks, but newer enterprises have a much more difficult time raising money. In the United States, the more competitive financial system gives more opportunity for entrepreneurs to raise start-up capital. As Barry Eichengreen put it,

Bank-based financial systems had been singularly effective at mobilizing resources for investment by existing enterprises using known technologies, but they were less conducive to growth in a period of heightened technological uncertainty.

-- (For more on Eichengreen's work, see Tyler Cowen.)

In Continental Europe, labor market regulations serve to keep small businesses small and to ossify the work forces at larger companies. In the United States, it is much easier for new businesses to expand and for old businesses to shed unnecessary workers.

European government policies sacrifice economic dynamism to other goals. For example, Joseph H. Golec and John A. Vernon recently wrote,

EU countries closely regulate pharmaceutical prices whereas the U.S. does not...In 1986, EU pharmaceutical R&D exceeded U.S. R&D by about 24 percent, but by 2004, EU R&D trailed U.S. R&D by about 15 percent. During these 19 years, U.S. R&D spending grew at a real annual compound rate of 8.8 percent, while EU R&D spending grew at a real 5.4 percent rate. Results show that EU consumers enjoyed much lower pharmaceutical price inflation, however, at a cost of 46 fewer new medicines introduced by EU firms and 1680 fewer EU research jobs.

Continental Europe is set up to preserve large public sectors, large banks, and large corporations. For individuals, the promise is stable jobs, a stable business environment, and collective sharing of the costs of unemployment, retirement, and health care. For the economy as a whole, however, the result is stagnation, inefficiency, and a burden on the working population to support the unproductive sector that is becoming increasingly unsustainable.

Over time, Europeans with entrepreneurial inclinations will be increasingly tempted to emigrate to the United States or other countries in the Anglosphere. Among the remaining Europeans, political support for welfare-state policies will solidify, even as the economic viability of those policies slips further.

Crime and Corruption

An entrepreneurial culture can emerge only in a setting where private property enjoys protection. When government fails to prevent crime, or when government corruption and expropriation serve the same functions as crime, the price for entrepreneurs is steep. A recent New York Times story summarized research done by a number of international agencies on the cost of crime in Latin America.

Years of rampant violent crime is not only robbing Latin America of significant private investment, but in some cases is stealing up to 8 percent from national economic growth, economists and World Bank officials say.

..."You have money spent on guarding stuff rather than making stuff," said Michael Hood, Latin America economist for Barclays Capital. "There's a large population standing around in blue blazers rather than engaged in more productive activities."

Much of the cost of government corruption is inflicted on start-up businesses. The World Bank and Canada's Fraser Institute have both documented the difficulties of doing business in many underdeveloped countries.

The Ethics of Growth, Once Again

Four years ago on TCS, I wrote that a nation's prosperity depends on three ethics: a work ethic, a public service ethic, and a learning ethic. The work ethic means that people believe that those who are willing to work deserve more rewards than those who are not. A public service ethic means that government officials are expected to protect private property, not to extort it. And a learning ethic means that people expect to learn, innovate, and adapt, rather than to resist change.

In the underdeveloped world, the work ethic and the public service ethic have not flourished. Instead, crime and corruption sap the economy, and entrepreneurship is particularly frustrated.

Continental Europe does not suffer such severe problems with the work ethic and the public service ethic. However, an important part of the learning ethic is taking advantage of the decentralized, trial-and-error process of entrepreneurial success and failure. The Continental European system attempts to replace the learning of decentralized markets with bureaucratic planning. Individual change agents have little access to capital and less opportunity to earn large individual rewards.

Ultimately, Europe's corporatist, bureaucratic model impedes learning and retards innovation. With its barriers to entrepreneurship, which are particularly discouraging to change agents, European economic growth has lagged behind during the last two decades of rapid technological change.

America's Natural Allies

If the United States is exceptional because of our entrepreneurial culture, then our natural allies may not be in Continental Europe, in spite of its democratic governments and high levels of economic development. China seems more dynamic than Europe, but I would argue that China's government-controlled financial system ultimately is not compatible with American-style entrepreneurship. Instead, we may have more in common with other nations of the Anglosphere, as well as such entrepreneurial outposts as India, Israel, and Singapore.

For the half century following World War II, the United States focused on democracy as the cornerstone of foreign policy. Democratic nations were our allies, and promoting democracy abroad was a top priority. However, it may be that American exceptionalism mostly reflects entrepreneurship. In that case, we have less in common with European social democracy than we thought previously. And, if our goal is to have more countries that look like America, then having them adopt a democratic political system may not be necessary and will certainly not be sufficient. Instead, our primary focus should be on fostering an entrepreneurial economic system. As Nobel Laureate Phelps put it,

I conclude that capitalism is justified -- normally by the expectable benefits to the lowest-paid workers but, failing that, by the injustice of depriving entrepreneurial types (as well as other creative people) of opportunities for their self-expression.

Arnold Kling is an adjunct scholar with the Cato Institute. His most recent book is Crisis of Abundance: Re-thinking How We Pay for Health Care.

China's Shanghai Composite Index tumbled 8.84 percent Feb. 27, its largest fall in a decade. Its sister index, the Shenzhen Composite Index, fell 8.54 percent. The size of the drop in China is not significant in and of itself. On a number of occasions during the past year, the Shanghai Stock Exchange has experienced 5 percent plus daily reductions, and it has already boomed and busted once this decade.

But that hardly means the development is insignificant. The fall is important both for how it happened and what it triggered.

How it Happened

This was an engineered drop.

The Chinese government has become increasingly concerned about levels of investment in its economy or, more accurately, the sheer amount of money that is chasing projects. State firms with limitless access to subsidized capital from state banks have used that access to launch thousands of nonprofitable firms. This glut in "investment" money drives up the cost of commodities and adds industrial capacity without actually producing anything of much use, making life more difficult for the average Chinese and unduly harming relations with foreign powers that face a glut of otherwise noncompetitive Chinese goods.

This penchant for overinvestment has now spread to the stock market in two ways. First, the same politically connected government officials who started dud companies are taking out loans to buy shares, or are using shares they already hold as collateral for new loans. Second, ordinary Chinese citizens have started borrowing -- sometimes against their homes -- in order to play the market. In January, the number of total traders on the Chinese exchanges grew by 1.38 million, an increase of 134 percent from a month earlier, while stock turnover was up 700 percent from a year earlier.

The net result is an absurd stock surge with no basis in fundamentals. At present, some Chinese banks now have price-to-earnings ratios higher than financial behemoths such as Deutsche Bank and Chase, despite deplorable management and a history of highly questionable lending policies.

For the past few months, the government has been working to drive down this speculative investing. On Feb. 26, China's State Council launched a new "special task force" that accurately could be referred to as the "get-those-idiots-to-stop-borrowing-to-gamble-on-the-stock-exchanges" team. Its express goal is to get the Chinese domestic security brokers to lay off such speculative decision-making, while also putting a crimp in the source of the subsidized capital.

Day one started by the script, and Beijing is likely quite pleased with the way things are going (or at least it was until its actions unintentionally triggered a global meltdown). Also, since the Shanghai exchange is actually still up 3 percent for the past week despite suffering its largest drop in a decade, the State Council probably hopes for more drops in the days ahead.

What it Triggered

But the rest of the world took a different lesson. Why the Chinese stock crash occurred was unimportant to the outside world, only that it did -- and that it affected everyone else.

For the first time, China has become the trendsetter in the global stock community. Normally, the U.S. exchanges -- especially the S&P 500 index and the Dow Jones Industrial Average -- set the tone for global trading patterns. Not on Feb. 27. This time, China led Asia to a wretched day. The wider the contagion spread, the more margin calls were forced to be called in. (If an account's value falls below a minimum required level, the broker will issue a margin call for the account holder to either deposit more cash or sell securities to fix the problem.)

As the drops snowballed, Europe filed in dutifully behind, mixing the China malaise with its own nervousness about overextended markets in Central Europe and the former Soviet Union. By the time markets opened in the United States -- where investors already were fretting about the subprime mortgage markets -- the only question remaining was how far U.S. markets would descend. In the end, the Dow dropped by the most since the fall triggered by the 9/11 attacks.

So why has this not happened before now? As China's market capitalization has increased, its links to the global system have increased apace. These links have developed very quickly, and with few controls. The Shanghai exchange, for example, more than tripled in total value in 2006 to more than $900 billion -- and much of the rapid-fire initial public offerings (IPOs) of Chinese banks on the Hong Kong and other international exchanges are not included in that little factoid. Indeed, China's mainland exchanges are only the tip of the iceberg -- and they certainly do not include foreign firms that are heavily invested in the mainland.

Two years ago, China's market capitalization was too small for its problems to impact the global system. Now, between ridiculous foreign subscriptions to IPOs, irresponsible corporate policies and irrational valuations all around, that capitalization is to a level -- around $1.3 trillion -- where its integration with the global system via funds and margins makes China a sizable chunk of the international financial landscape. The insulation that once protected international exchanges from Chinese policies is gone, which makes the international system more vulnerable to Chinese crashes.

Feb. 28 and Beyond

Follow-on crashes can come from one of three places.

First, the Chinese believe their exchanges are massively overvalued (hence the engineered crash). They will do this again, and are not (yet) particularly concerned with the international consequences. China planned to dampen its own stock market, not the world's markets. Along with the rest of the world, Beijing did not expect the contagion effect to be so extreme. Yet, for now at least, China's own exchanges are its primary concern, and it will act according to that belief.

Second, everyone else now is going to chew on the fact that Beijing did this intentionally. They will either agree with the Chinese that the exchanges are overvalued and that additional measures are needed, or they will be terrified that Beijing did this intentionally and not care about the reasons. Whether what is sold is a domestic Chinese firm or a foreign firm invested in China does not matter much. Neither does it matter if the stock is on an exchange in China or abroad. Either way, the reaction will be the same: Sell.

Third, trading in 800 of the 1,400 stocks on the Shanghai exchange was suspended during the sudden drops Feb. 27; they have a lot farther to fall, even without any engineered drops caused by panicky selling.

Considering the flaws on which the Chinese system is based, this certainly will not be the last engineered drop. In theory, the move will make foreign investors far more cautious before diving into the Chinese system, but as longtime Stratfor readers know, we have been wrong on the timing of that particular development before.

Credit Correction Will the Fed and the Democratic Congress tempt a larger stock market selloff?

Wednesday, February 28, 2007 12:01 a.m. EST

Any equity selloff as large as yesterday's will produce a multitude of explanations. Among other culprits, we heard about "overbought" Chinese stocks that were due for a correction, a weak durable goods report, the Kabul explosion aimed at Vice President Dick Cheney (see below), and former Federal Reserve Chairman Alan Greenspan for declaring Monday that a "recession" was possible later this year.

Our own "whodunit" contribution would point to the mortgage-related markets, which sold off nearly as much as stocks. This reflects the cracks appearing in the housing credit markets, especially in subprime loans but with some damage up the income chain as well. Along with emerging markets such as China, this is where the excesses have been most notable. And when Adam Smith does a house cleaning like yesterday's, he sweeps the dirtiest corners first.

The question is whether this is a forecast or merely a correction. As evidence of the latter, we'd point to Mr. Greenspan, whose Monday remarks seem to have been over-interpreted as a recession prediction. In the same discussion, we're told, he called the world economy "benign and stable." Nonetheless, we'd also note that Mr. Greenspan's predecessor as Fed Chairman, Paul Volcker, didn't muse about recession dangers after he left office in the 1980s. He didn't want to complicate Mr. Greenspan's monetary task at the time.

We also wouldn't make too much of one month's decline in durable goods. These are notoriously volatile, especially in transportation, which was way down in January. Today's report on fourth quarter GDP is also widely expected to be revised downward from the original 3.5%. But much of that revision may be due to an inventory work off, which bodes better for growth going forward. The labor market remains strong, if slowing from the rapid pace of job growth in 2006.

The bigger risks continue to be political and monetary. The era of tax cutting has ended with the arrival of the Democratic Congress, and other policy errors are possible. As for the Fed, we'd feel better if current Chairman Ben Bernanke had been running a tighter monetary policy for the last year; it might have left him with more policy room if the economy does turn sour. As it is, any easing now runs the risk of a dollar rout, which could lead to an even larger loss of confidence and selloff.The current problems in the housing credit markets owe a great deal already to the Fed's mistake in keeping monetary policy too easy for too long during the late Greenspan era. We now have to ride them out, and Mr. Bernanke shouldn't make them worse with a panicky, premature easing.

"Among all families with children, the poorest fifth had the fastest overall earnings growth over the 15 years measured."

The poor have been getting less poor, according to a new study by the Congressional Budget Office. On average, CBO found that low-wage households with children had incomes after inflation that were more than one-third higher in 2005 than in 1991.

The CBO results don't fit the prevailing media stereotype of the U.S. economy as a richer take all affair -- which may explain why you haven't read about them:

* Among all families with children, the poorest fifth had the fastest overall earnings growth over the 15 years measured. * The poorest even had higher earnings growth than the richest 20 percent. * The earnings of these poor households are about 80 percent higher today than in the early 1990s.

What happened?

* CBO says the main causes of this low-income earnings surge have been a combination of welfare reform, expansion of the earned income tax credit and wage gains from a tight labor market, especially in the late stages of the 1990s expansion. * Though cash welfare fell as a share of overall income (which includes government benefits), earnings from work climbed sharply as the 1996 welfare reform pushed at least one family breadwinner into the job market.

Earnings growth tapered off as the economy slowed in the early part of this decade, but earnings for low-income families have still nearly doubled in the years since welfare reform became law. Some two million welfare mothers have left the dole for jobs since the mid-1990s. Far from being a disaster for the poor, as most on the left claimed when it was debated, welfare reform has proven to be a boon.

"Amazing how this CBO study received absolutely no coverage and amazing that the Republicans have not made use of it.Perhaps Newt Gingrich, who certainly had a big hand in the welfare reform, will use it if he runs"

Agreed. Welfare reform and also capital gains rate cuts were the two big accomplishments of that congress, causing the great economic expansion to continue in this country. I think most people, via our media, remember Newt for the shutdown (Clinton's fault) and his "whither on the vine" remark (which had to do with a obsoleting a bureaucracy, not cutting off our grandparents) and they remember Clinton for a great economy (where credit should go more to Newt and even Reagan). I already read the rapid response of liberal bloggers to this study saying these numbers are skewed because the start date of 1991 was a recession year. (You might recall - that wasn't much of a recession.) The Democrat candidates pick stats that start at the height of the bubble to show what little progress has been made. You just exposed which numbers the media will latch onto.

IMO, public policy has a (limited) interest in watching out for the well being of the poorest among us, but no legitimate interest in the so-called 'widening gap' which means putting limits on success.

Concerning "widening gap", I remember in the early Reagan years there was much indignation about the widening gap between rich and poor, blah blah. What these economic illiterates did not understand was that with the cut of the top tax rate from 70% to 30% it made more sense to allow the money to be taxed than to keep it in the shelters-- hence the dramatic increase in "the rich" in government data.

The New York Times headline -- "Tax Cuts Offer Most for Very Rich" -- said it all. That claim was uncritically repeated by CNN, posted on Brad DeLong's blog and so on. But was it true? The report by Edmund Andrews was about the latest "Historical Effective Tax Rates" from the Congressional Budget Office (CBO). The CBO shows that from 2000 (the year before President Bush cut tax rates) to 2004, the after-tax income of the very richest 1 percent fell by 7.9 percent. After taking into account the Bush tax cuts, the 8.3 percent drop in after-tax incomes of the top 1 percent was even worse. From 2000 to 2004, average real incomes of the middle three-fifths rose 4.1 percent after-taxes, but only 0.5 percent before taxes. In other words, 88 percent of middle-income gains between 2000 and 2004 were due to those nefarious Bush tax cuts of 2003. Those who rely on the New York Times (unlike readers of The Washington Times), will never find out what the CBO report reveals unless they go to cbo.gov and read it. To have any chance of his story appearing in the New York Times, Mr. Andrews had no choice but to dissemble. He began by saying, "Families earning more than $1 million a year saw their federal tax rates drop more sharply than any group in the country as a result of President Bush's tax cuts, according to a new congressional study." But the top 1 percent of households (not families) are those earning more than $266,800 -- not more than $1 million. The average income for everyone earning more than $266,800 exceeds $1 million, but such a mean average is bloated by a small number of very high incomes, particularly distributed earnings of Subchapter S-corporations. This is why we use median income to describe typical income in other cases, and should also do so when describing average income of top income groups (which differ from lower groups because income has no upper limit). Mr. Andrews continued, "Though tax cuts for the rich were bigger than those for other groups, the wealthiest families paid a bigger share of total taxes. That is because their incomes have climbed far more rapidly, and the gap between rich and poor has widened in the last several years." Unless "last several years" excludes 2000, the statement is brazenly false. It makes no sense to start with any year except 2000 because we can't possibly compare incomes and taxes before and after the Bush tax cuts unless we begin with the last year of the Clinton presidency. That is, after all, the tax regime congressional Democrats set up as their ideal when they criticize the Bush tax changes as unduly generous to the top 1 percent. Measured in constant 2004 dollars, average income of the top 1 percent was $1,413,000 in 2000, but only $1,259,700 in 2004 -- a drop of 7.9 percent. Tax cuts did not help a bit. After-tax income of the top 1 percent fell from $946,300 to $887,800 -- an even larger 8.3 percent decline. Mr. Andrews says, "Economists and tax analysts have long known that the biggest dollar value of Mr. Bush's tax cuts goes to people at the very top income levels." You don't need to be an economist to discern that "the biggest dollar value" of any equiproportionate tax cut must go to those with the "biggest dollar value" of taxes paid. Yet the top 1 percent did not get anything remotely close to a proportionate share of the tax cuts after 2000. The article says "the wealthiest families paid a bigger share of total taxes," but what is remarkable is that they even paid a larger share than they did in 2000, although their before-tax incomes were 7.2 percent smaller. That explains why the top 1 percent's after-tax income fell even more than their before-tax income. The top 1 percent ended up with 14 percent of after-tax income, down from 15? percent in 2000, and that includes one-time capital gains and a seriously exaggerated share of corporate profits. Mr. Andrews added that "two of [the president's] signature measures, tax cuts on investment income and a steady reduction of estate taxes, overwhelmingly benefit the wealthiest households."

That sentence is half irrelevant, half mistaken. The CBO does not attempt to assign the estate tax by income group. To do that, they would have to know who received the money, not who died. Dead people cannot receive more income, before or after taxes, just one reason death is a highly undesirable tax avoidance strategy. If Hugh Jassets dies and leaves $10 million to be split among 10 young grandchildren, those youngsters are likely to be either invisible or poor in terms of income showing up in CBO tax data. Second, taxes on capital gains and dividends are surprisingly hard on older retirees with low incomes. Those with incomes below $15,000 paid more than 7 percent of the federal taxes on dividends in 2002, and those with incomes below $200,000 paid 62 percent of that tax. Third, lower tax rates on taxable dividends and capital gains generally result in investors paying more taxes on their investment income, not less. Nobody has to hold dividend-paying stock in a taxable account, and nobody has to report capital gains by selling assets from a taxable account. The amount of dividend income reported to the IRS doubled from 2002 to 2004. Upper-income taxpayers are bound to be reporting relatively less income from tax-exempt bonds than they did before 2003. Moving income from nontaxable to taxable investments looks like an increase in top incomes in the CBO estimates, but it isn't. There has been a lot of chatter lately about raising Social Security taxes only on those with incomes above $100,000 while cutting the same group's Social Security benefits again (their benefits were deeply slashed in 1993 through an extra tax on benefits). Can anyone really pretend that sounds "fair"? The CBO calculates the effective tax rate for all federal taxes -- including Social Security and Medicare taxes, income taxes and excise taxes. For the bottom 80 percent as a group, that total federal tax fell from 14.1 percent in 2000 to 11.4 percent in 2004 -- a 19.1 percent tax cut. The tax cut was deepest among the poorest fifth (29.7 percent), largely because of the Bush administration's refundable tax credit for children. For the middle fifth, the total tax rate fell from 16.6 percent to 13.9 percent -- a 16.3 percent cut. As for the top 1 percent, their overall tax rate was merely trimmed from 33 percent to 31.1 percent -- a 5.8 percent cut A courageous (willing to be fired) New York Times ombudsman would insist on the following correction to Mr. Andrews' upside-down article: "Households earning more than $266,800 a year saw their federal tax rates drop less sharply than any other group in the country as a result of President Bush's tax cuts, according to a new Congressional Budget Office study."

Alan Reynolds is a nationally syndicated columnist and a senior fellow with the Cato Institute.

Interest rates are on the rise in the Eurozone, Great Britain and Japan, as well as in India and China. But the Federal Reserve has again elected to keep its target rate on hold despite repeated assertions that inflation risk is still its predominant concern. Are central banks abroad recognizing a threat that their American counterpart has yet to acknowledge?

The Fed seems to believe that inflation has something to do with "excessive" demand. Although it admits that inflation is already running at an unacceptable pace, the majority of its policy officials cling to the belief (or hope) that the U.S. economy is slowing down, alleviating the inflation threat. Both of these assumptions are inconsistent with historical evidence.

What's more, the recent rise in the euro and sterling relative to the dollar has obscured the fact that the world economy has embarked on another classic "run" on paper currencies that is driving inflation up everywhere. For several years now, as was the case in the 1970s, all the world's currencies have been depreciating relative to stable benchmarks such as gold. Since the end of 2001, these declines have ranged from 38% (in the case of the euro) to nearly 60% (in the case of the dollar).

Why then has the pace of consumer-price inflation to date been so much less noteworthy than the pace of currency depreciation against gold? The answer lies in the timing: Gold is a fast-moving leading indicator, whereas consumer-price indices are slow-moving indicators that lag far behind. We all learned in the period between 1975 and 1985 that consumer prices do eventually catch up. It is the size of the move in the gold price, rather than in the consumer price index, that is a true and timely indicator of the magnitude of the inflation problem.

In 1975, Yale economist Richard Cooper described the process that now appears to be driving world inflation as "a general loss of confidence in money, a psychological mood that can be transmitted across national boundaries . . . [that will] lead individuals to try to convert their assets into physical form: goods or housing or real estate."

But why does this phenomenon break out at some times and not at others? Why is it sometimes local and sometimes global? History provides the answer. Following World War II, rapidly rising prices began to be accepted as an inevitable -- even "normal" -- fact of life. But in reality, up to and including the 19th century, significant inflation had been the exception rather than the rule. And when it did occur it was usually local rather than global. In the U.S., for example, cumulative consumer-price inflation was zero from 1820 to 1913, just prior to World War I. In the United Kingdom, consumer prices were lower at the beginning of World War II than they had been in 1800. In England the prices of consumables rose at an average annual rate of less than 0.4% over the centuries-long run between 1210 and 1940.

Against this relatively stable background, inflation erupted when nations faced acute fiscal stress, particularly in times of all-out war. A government that lost a war of survival typically saw the value of its paper currency evaporate to zero. In the final stages of this process, hyperinflation and astronomical interest rates accompanied economic chaos. The defeated government either did not survive (such as the Confederacy in 1865) or had to be rescued from its currency crisis by the victors (as in Germany and Austria in 1923 and Germany and Japan after 1945). Even the winners of all-out wars, especially those that emerged seriously impoverished (such as Britain in 1945), resorted to currency devaluations and suffered high inflation as a result.

In all cases, inflation was related to the inability or unwillingness of the governing authorities to maintain a stable currency in times of war-related government spending and debt. Although we are not entirely at peace today, U.S. military activity is at nothing like the all-out scale from 1917-1918 or 1941-1945. So why are we having an inflation problem, and why is it global in scope? There are two culprits.

First, since 1971 no government had made an attempt to fix the gold value of its currency, and every political initiative that raises long-term government spending leaves the financial markets free to price currencies at a lower gold value. Depreciation of currencies relative to gold has become unpredictable, chronic and planet-wide.

Second, the massive increase in the public-sector share of the economy that occurred in World War II (and was reinvigorated in the late 1960s) has become permanent. In place of war-related debt, public finance is now saddled with long-range government spending commitments, including burgeoning debt in the form of unfunded liabilities associated with national pensions and health insurance. The popular notion that inflation is the way politicians reduce public debt without formally abrogating it is not far from the truth. In a nutshell, inflation is a manifestation of looming government insolvency.

This problem vastly overshadows the federal budget deficits with which Washington is obsessed. The military costs of the "war on terror" and the Iraq conflict are mere addenda to a mountain of obligations, which financial markets are warning that the federal government can only discharge by inflating away.

Not that the other world economies are in any better fiscal shape than America's. In fact, throughout the 20th century, the U.S. has been a sort of lender of last resort. If we had not been on the scene in 1923, who else could have underwritten a new and viable currency for Weimar Germany? Though in recent times our allies in North America and Europe have been less warlike than us, they long ago adopted much more generous social "safety nets" and thereby undermined their long-term solvency to an even greater degree than here.

Inflation was negative following the Civil War, when the price of gold fell back to its pre-war parity. Inflation was likewise low after World War I when the price of gold remained fixed. In contrast, inflation charged ahead after World War II as the market price of gold was permitted to rise. Broadly speaking, although a rise in the price of gold is a sufficient condition for consumer-price inflation, it is not entirely necessary. The shortages that occur in a widespread war (such as World War I) may be sufficient to push up the price level, despite price controls and adherence to the gold standard.

Inflation is not intrinsically global -- it is obvious that some countries experience more inflation than others. But currencies depreciating against gold across the board is a sign of world-wide inflation -- and it has begun to set off alarm bells in many major economic capitals. But in Washington, our own central bankers remain placidly confident that everything will turn out all right.

Unsustainable peacetime spending is a much slower process than the unsustainable war spending. Far from sudden death, currencies these days are facing death by a thousand cuts. The unfortunate result is that the current crisis of confidence in paper money goes largely undiagnosed by the bulk of economists and policy makers.

We're Number One, AlasJuly 13, 2007; Page A12Some good news on the tax cutting front: Last week lawmakers approved an 8.9 percentage point reduction in the corporate income tax rate. Too bad the tax cutters are Germans, not Americans.

There's a trend here. At least 25 developed nations have adopted Reaganite corporate income tax rate cuts since 2001. The U.S. is conspicuously not one of them. Vietnam has recently announced it is cutting its corporate rate to 25% from 28%. Singapore has approved a corporate tax cut to 18% from 20% to compete with low-tax Hong Kong's rate of 17.5%, and Northern Ireland is making a bid to slash its corporate tax rate to 12.5% to keep pace with the same low rate in the prosperous Republic of Ireland. Even in France, of all places, new President Nicolas Sarkozy has proposed reducing the corporate tax rate to 25% from 34.4%.

What do politicians in these countries understand that the U.S. Congress doesn't? Perhaps they've read "International Competitiveness for Dummies." In each of the countries that have cut corporate tax rates this year, the motivation has been the same -- to boost the nation's attractiveness as a location for international investment. Germany's overall rate will fall to 29.8% by 2008 from 38.7%. Remarkably, at the start of this decade Germany's corporate tax rate was 52%.

All of which means that the U.S. now has the unflattering distinction of having the developed world's highest corporate tax rate of 39.3% (35% federal plus a state average of 4.3%), according to the Tax Foundation. While Ronald Reagan led the "wave of corporate income tax rate reduction" in the 1980s, the Tax Foundation says, "the U.S. is lagging behind this time."

Foreign leaders are also learning another lesson: Lower corporate tax rates with fewer loopholes can lead to more, not less, tax revenue from business. The nearby chart shows the Laffer Curve effect from business taxation. Tax receipts tend to fall below their optimum potential when corporate tax rates are so high that they lead to the creation of loopholes and the incentive to move income to countries with a lower tax rate. Ireland is the classic case of a nation on the "correct side" of this curve. It has a 12.5% corporate rate, nearly the lowest in the world, and yet collects 3.6% of GDP in corporate revenues, well above the international average.

The U.S., by contrast, with its near 40% rate has been averaging less than 2.5% of GDP in corporate receipts. Kevin Hassett, an economist at the American Enterprise Institute who has studied the impact of corporate taxes, says the U.S. "appears to be a nation on the wrong side of the Laffer Curve: We could collect more revenues with a lower corporate tax rate."

If only the tax writers in Washington would heed this advice. Congress is moving in the reverse direction, threatening to raise the tax rate on corporate dividends, which is another tax on business income. There's also movement in the Senate to raise taxes on the foreign-source income of U.S. companies. The effect would be to raise the marginal tax rate for companies that base their corporate headquarters abroad.

But one reason those countries chose to move to the Cayman Islands and elsewhere is because of the high U.S. corporate tax rate. The Laffer Curve analysis indicates that these corporate tax increases are likely to raise little if any additional revenue, because companies will have a new incentive to move even more of their operations out of the reach of the IRS.

For all the talk of "tax equity," this is also a recipe for further inequality by driving more capital offshore. Research from Mr. Hassett and others has shown that high corporate tax rates reduce the rate of increase in manufacturing wages (See our editorial, "The Wages of Growth," Dec. 26, 2006.). For that matter, most economists understand that corporations don't ultimately pay any taxes. They merely serve as a collection agent, passing along the cost of those taxes in some combination of lower returns for shareholders, higher prices for customers, or lower compensation for employees. In other words, America's high corporate tax rates are an indirect, but still damaging, tax on average American workers.

One immediate policy remedy would be to cut the 35% U.S. federal corporate tax rate to the industrial nation average of 29%. That's probably too sensible for a Congress gripped by a desire to soak the rich and punish business, but a Democrat who picked up the idea could turn the tax tables on Republicans in 2008. Meantime, as the U.S. fails to act, the rest of the world is looking more attractive all the time.

The main fallacy in monetary theory and policy is the confusion of money and wealth. Money is wealth from the individual perspective since individuals can usually exchange it for goods and services. Money -- and financial assets easily converted to money -- may not be wealth for society as a whole if the production of goods and services has not kept pace with claims on it. Early spenders may have some success, but inflation will dilute the buying power of others. The bottom line is that real wealth has to be produced; it can't be printed.

Don't call me a Keynesian, but Keynes's Paradox of Thrift is another example of the fallacy of composition -- what's true for the individual may not be true for the group. Most U.S. families should be saving more. Indeed, the personal saving rate -- the percentage of disposable income not spent on consumption -- hovers around zero, with frequent dips into negative territory. This is made possible, for a while, by selling assets, accumulating debt, or spending capital gains in the housing and stock markets. Money obtained by realizing capital gains spends as well as money earned on the job. But not if too many of us try it at once.

The Paradox of Thrift says that attempts to save more in the aggregate reduce consumption spending, which, if not offset by increases in other spending, will reduce total spending and income. The paradox comes in when attempts to save more results in reduced saving out of lower incomes. The irony is that policy makers advise more saving but those who take the advice will benefit only if most of us ignore it, and policy makers are implicitly counting on that outcome.

A parallel is the farmer who hopes for a good crop year. But, if all or most farmers have a good crop year, the decline in prices may more than offset higher yields. What our farmer really needs is a good crop in a bad crop year. Then he could look for a popular restaurant that isn't crowded.

I realize this is not very sophisticated stuff, but it's on my mind because of the many talking heads I hear dismissing the adverse consequences of our low personal saving rate by saying it ignores capital gains as a source of spending. "Properly measured," they say, saving is not a problem.

Again, that may be true for the few, but not for the many. A penny saved may be a penny earned, but it matters whether it was earned by producing more or by a rise in the price of existing financial assets. A stock or housing market boom creates apparent wealth in the form of capital gains, but trying to convert it to real wealth en masse can make it disappear.

Economists say the main reason they worry about the budget deficit or the current account deficit is their impact on domestic saving. But my guess is that only other economists really get their meaning. Most people may be even further misled by the implication they hear that since the main harm of deficits is their impact on saving, they must not be too harmful after all. The old-fashioned notion that deficits are bad because they create debt that must be paid back with interest is probably a better prod to constructive behavior. Or that deficits impose a burden on our children or grandchildren.

Alan Greenspan has been one of the few economists to explain these matters correctly and -- I can't believe I'm saying this -- understandably, usually in the context of Social Security or other entitlement reforms. Whenever confronted by various financial fixes during congressional testimony, he frequently pointed out that any solution to the problem had to include real economic growth. With claims on output growing rapidly, output has to grow equally rapidly, or the claims are bogus. Any solution to our entitlement problems must include a bigger, more productive economy in the future. It's really as simple as not selling more tickets to the Super Bowl than there are -- or will be -- seats in the stadium. Of course, the political preoccupation with distribution rather than production puts unnecessary limits on the size of the economy on Super Bowl day.

The problem goes beyond government entitlement programs. Consider the baby boomers whose IRAs, 401(k)s and personal investments helped drive the stock market to record highs. What happens when cash-in time comes? There will be a mountain of paper claims on output, but will there be an equally tall mountain of output?

The great French economist, Frederic Bastiat, said that "The state is the great fictitious entity by which everyone seeks to live at the expense of everyone else." It's time to get real about producing real wealth, not just financial claims on wealth.

Mr. McTeer is a fellow at National Center for Policy Analysis and former president of the Dallas Fed.

An exchange from an email group of which I am a member. "Scott" is Scott Grannis, noted supply side economist:===================

Pat is pointing out is that a house purchase triggers other consumption purchases -- furniture, appliances, and so on. The production of these consumption items creates wealth. The people who saved and then built the lumber mills, cement factories, steel factories, appliance factories, housing construction firms, and all the rest are the people we can thank for the bounty of goods available.

The people who buy houses should be exchanging the value of their production -- whatever it might be --- for the production by residential housing constructors and all the other goods makers in the chain of residential housing activity. Normally, that would be the only way to buy a house. Or, a house buyer could borrow money from somebody else who produced something of equivalent value.

Unfortunately, we have evolved a system where mortgage money is created out of thin air and the house buyer uses that new money to bid houses away from other buyers. It's true, as Scott said, that the more desirable neighborhoods can see price increases without monetary inflation -- but that would normally be accompanied by falling prices in less desirable neighborhoods. With rampant credit inflation anybody willing to borrow can move up to a more desirable neighborhood or buy that first house. The result is rising house prices almost everywhere.

By the way, buying stock on the secondary stock market adds nothing to the country's productive capacity. It adds no wealth. The secondary markets are price-discovery markets. A security's price presumably gives us the current valuation of the "factors of production" -- one key to the capitalism's effectiveness. In a socialist economy the factors of production are not privately owned and there is no way to set meaningful prices. The result is an inability, for example, to decide whether it is economically desirable to build a new factory or rejuvenate an old one -- i.e. "economic calculation" is impossible.

Unfortunately, if a capitalistic country's price discovery mechanisms are distorted by inflation it causes analogous difficulties. Entrepreneurs look at distorted prices and make poor economic decisions. All you have to do is look at all the record breaking deals financed by debt to see that our price setting mechanisms have been distorted to some unknown degree by our ongoing credit expansion.

Tom===============Tom, I'm as worried about inflation as anyone I know in the professional money management business, but I think your concerns go over the top. My inflation credentials, by the way, go back to the 4 years I lived in Argentina during the late 1970s. I lived and breathed hyperinflation for years, and I've spent many years since then studying how and why it happened.

It is simply not true that "mortgage money is created out of thin air" as you say. If that were the case then the US money supply would be growing by staggering amounts. Instead, money supply (M1 or M2, take your pick) is growing at very modest rates that are completely consistent with low inflation (i.e., less than 6%). If you take out a mortgage to buy a house, essentially 100% of the money you receive comes out of the pocket of someone else. Almost no one buys a house these days the old-fashioned way ( i.e., from a bank), which means banks are not out there creating money thanks to the fractional reserve system. Very few banks these days are in the business of making AND HOLDING mortgages in their portfolios. Lots of banks make mortgages, but the vast majority are sold to other investors like my firm. Very few, very few hold those mortgages in their portfolios. That's the only way that money can be created out of thin air. That the money supply is growing slowly is pretty much proof of this.

I've talked about this before, but you and other Austrians are obsessed with the notion of credit bubbles and credit inflation. What you don't seem to understand is that credit expansion these days is a private sector phenomenon and has nothing to do with monetary policy or inflation. If I create a business that has a high probability of creating a future cash flow stream, I can monetize that cash flow by issuing a bond. Someone buys that bond from me with cash. That cash is not created out of thin air. It is simply existing cash that changes hands. If my new business runs aground, then my expected cash flows fail to materialize and I default on the bond. The guy who owns the bond is out of luck. No new money was created in this process.

As for inflation, the Fed can create that by setting interest rates too low. It doesn't require money expansion, it just requires interest rates (which are the only thing the Fed attempts to control) that are too low. Low interest rates undermine the demand for money, and falling money demand results in a more rapid circulation of money, and it is rising money velocity that fuels higher prices. You can observe this process by watching the declining value of the dollar and the rising gold price, and rising prices for hard assets such as real estate and commodities. What we have now is a mild but persistent inflation that could easily last for several more years. But it's definitely not an inflation like what we saw here in the 1970s. Of course, if the dollar were to fall another 15-20% then I might change my assessment, but that remains to be seen.

And as a side note, it is perfectly legitimate for home prices to rise if interest rates fall. A home is like any asset that produces future benefits: the present value of those benefits is their discounted present value. Lower interest rates boost the value of any productive asset.

-Scott===============Scott,

I understand your points, but let me point out a couple of things and ask some other questions. From Doug Noland's last weekly report: "M2 (narrow) "money" increased $4.5bn to a record $7.264 TN (week of 7/2). Narrow "money" has expanded $220bn y-t-d, or 6.0% annualized, and $438bn, or 6.4%, over the past year."

Isn't a 6.4% growth rate in M2 rather significant? If it is true that the great majority of that new money goes into real estate construction or various forms of speculative finance, it seems that rate of money creation could distort the relevant prices to a huge degree -- and that is what the Austrian theory says is the cause of malinvestment and economic .

It's true, as you say, that when the banks sell off loans that action prevents those loans from adding to the M2 balances. But banks do keep some loans! Also, many mortgage backed security buyers are highly leveraged hedge funds or other leveraged speculators -- and their leverage is normally obtained from a bank. If the M2 data is correct, the net result is a "moderate" rate of monetary increase instead of a sky rocketing rate -- but 6.4% is sufficient to damage to our economy and transfer countless billions of wealth to the financial players.

When the Fed sets interest rates "too low" the inflationary mechanism, I believe, is primarily the impetuous given to credit expansion. Sure credit creation is a "private sector" phenomenon, but the private sector credit machine is coordinated and protected by the policies of the Fed and the US government. The result is absolutely bizarre behavior by people who are running multi-gazillion dollar enterprises in this industry. I am sure you saw this quote from the Citigroup CEO: July 10 – Financial Times (Michiyo Nakamoto and David Wighton): "Chuck Prince yesterday dismissed fears that the music was about to stop for the cheap credit-fuelled buy-out boom, declaring that Citigroup was 'still dancing'. The Citigroup chief executive told the Financial Times that the party would end at some point but there was so much liquidity at the moment it would not be disrupted by the turmoil in the US subprime mortgage market. He also denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back, in spite of problems with some financings. 'When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing,' he said… 'The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be. At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don't think we're at that point.'" The Austrian-School economists seem to be obsessed with inflation and credit expansions because their theory tells them that these are the mechanisms that lead directly to boom/bust cycles. The theory very explicitly explains why these consequences pertain, and I have yet to see anyone in the mainstream debunk this explanation. If you know of such a paper, I would love to see it.

Tom===================

In the past year M2 has grown 6.2%; in the past two years 5.5% (annualized); in the past three years 4.9% (annualized).

During the period in which U.S. inflation slowed from double digits (1980) to just 1% (mid 2002), M2 grew at a 6.0% annualized pace. During that same period, nominal GDP grew at a 6.3% pace and real GDP grew at a 3.0% pace (which is exactly the expected long-run growth rate of the economy). Money thus shrunk a bit relative to the size of the economy. The Fed was fighting inflation, and it worked, and it didn't kill or threaten the economy.

With M2 currently growing around 6% or a bit less (M1 hasn't grown at all for over two years, MZM is up at a 6.0% pace over the past two years), needless to say it's hard to make the case that rapid money growth is threatening higher inflation, at least based on the historical evidence. Current growth rates of money are entirely consistent with low inflation and a normal expansion of the economy.

If we are to have rising inflation with 6% M2 growth, we will need a rising velocity of money. There is indeed evidence of this, and it is the case that inflation has risen, albeit moderately, in the past three years--from a low of 1% to today's 2.5-3%.

Higher inflation coming on the heels of very low inflation, and perhaps even some deflation in the late 1990s and early 2000s, could well have stimulated the demand for real assets such as homes and gold and commodities. Lower interest rates, a by-product of collapsing inflation, were also responsible for stimulating the demand for housing.

Contrary to popular belief (and this is indeed heretical even among economists), declining inflation stimulates the demand for money and slows money velocity. Rising inflation tends to do the opposite. People don't want to hold a lot of money when prices are rising. So M2 growth tends to be slow when inflation is rising, and fast when inflation is falling. So just observing the growth of M2 tells you little about what the Fed is doing, or whether money growth is inflationary. Indeed, it is entirely possible that rapid credit and money expansion could occur alongside low and stable inflation. That is what we saw, in fact in the late 1990s and early 2000s.

In any event, let's stipulate that there is a huge expansion of credit in the private sector, and that easy access to credit has fueled a housing boom. If the Fed is doing its job and keeping inflation low, that housing boom will not have very long legs. If prices rise too much they will eventually fall. Lenders will lose a bundle, there will be lots of foreclosures, etc. Sound familiar?

Here's some advice to the Democrats on how to raise the revenues they'll need to pay for all the spending they have in mind. Don't hike the capital gains tax rate. Don't lower it, either. Eliminate the capital gains tax entirely.

How can tax revenues be increased by eliminating a tax? It's simple, when the tax in question is on capital gains. Capital itself exerts a multiplier effect that benefits the entire economy. Investment in new plant, equipment, business processes and whole companies creates new and higher paying jobs, and higher levels of economic activity, all of which generate additional tax revenues far in excess of what government would lose by foregoing cap-gains taxes.

This idea has broad theoretical support. Former Clinton Treasury Secretary Lawrence H. Summers has written, "the elimination of capital income taxation would have very substantial economic effects" which "might raise steady-state output by as much as 18%." Economist Jack L. Treynor has shown that "the level of taxation on capital that is 'fairest' -- i.e., most beneficial -- to labor is zero." And Nobel Prize-winning economist Robert E. Lucas, Jr., has concluded, "neither capital gains nor any of the income from capital should be taxed at all." These economists think in terms of very complex models. But the real-world intuition here is quite straightforward.

The cap-gains tax is a barrier to the investment of capital. Without it, capital will flow to investments that otherwise wouldn't have been made. The cost of eliminating the barrier is foregone revenues from that particular tax. But those revenues are small, usually deferred and non-recurring. In their place, government receives large and recurring revenues from corporate taxes, sales taxes, wage taxes and dividend taxes -- all generated by new economic activity.

The cap-gains tax is a poor revenue raiser, because any given capital gain is a one-time event that can only be taxed once, and in many cases, ends up not being taxed at all. Consider Microsoft. Since the company went public 20 years ago, its market value has increased by about $275 billion. A generous estimate of the cap-gains tax revenues we could expect from this increase is about $40 billion.

Actual collections will surely be less. Many shares will never be sold -- held by founders who wish to retain control, or by people who wish to avoid paying taxes. Many shares will be gifted to charitable foundations, as Bill Gates has done for the Bill and Melinda Gates Foundation, out of the tax collector's reach. Even for those shares that will eventually be sold, from today's perspective the resulting tax revenues have to be discounted, as they won't be collected for years.

At the same time, Microsoft has been a fountain of other tax revenues. Since the company went public, I estimate that, in cumulative present-value terms, corporate taxes already paid total roughly $60 billion; sales taxes paid by Microsoft's customers total roughly $11 billion; income taxes paid by Microsoft's employees total roughly $12 billion, and dividend taxes paid by Microsoft's shareholders total about $3 billion. These four sources of tax revenues over the last 20 years total $86 billion -- more than twice our generous estimate of the notional cap-gains tax revenues ($40 billion) for the same period.

Moreover, unless Microsoft's stock price increases -- which it's had a hard time doing the last couple years -- the estimated $40 billion in cap-gains tax revenues will never grow to a larger number. But corporate taxes, sales taxes, income taxes and dividend taxes will continue to be generated year after year. Even if assuming Microsoft's business stops growing (it has been reliably growing at better than 10% per year), the present value of the tax revenues from these other sources is roughly $182 billion. Added to the revenues already collected, the total is $268 billion.

There is also all the new taxable economic activity enabled by Microsoft's products. It's impossible to estimate a dollar value for it, but we can be sure it is a multiple of the value created within Microsoft. In this context, there is nothing unique about Microsoft. Anytime capital is invested, the small, deferred and non-recurring revenues that can be expected from the cap-gains tax are a tiny fraction of the perpetual revenues from other economic activities, generated directly and indirectly.

While eliminating the cap-gains tax may well induce companies like Microsoft to generate additional taxable activity, there's a more important opportunity here. Eliminating the cap-gains tax will cause the economy to generate more innovators like Microsoft.

For each new Microsoft, the cost to government would mean $40 billion in foregone revenues. But for those new Microsofts that wouldn't have existed otherwise, the payoff would mean raking in $268 billion.

That's a smart trade-off. If the Democrats were really interested in raising revenues -- and not just making life harder for a handful of wealthy private equity players -- it's a trade-off they should eagerly make.

Tremors from America's quaking subprime mortgage market have spread throughout the financial world. This latest disturbance in global financial markets is neither isolated nor idiosyncratic. It points to deeper, enduring changes in the structure of our markets -- changes that have profoundly altered the behavior of market participants in ways that tend to encourage risk-taking beyond prudent limits. Just as troubling is the failure of official policy makers to effectively rein in such excesses, leaving our financial system vulnerable to similar turmoil in the future.

The principal structural driver behind this and similar financial tribulations is the massive growth of financial markets, combined with a plethora of new credit instruments. By any measure, current financial activity -- new financing or secondary market trading volume -- dwarfs the past. The outstanding volume of nonfinancial debt now exceeds nominal GDP by $15 trillion, compared with $6 trillion a decade ago. Traditional credit instruments such as stocks, bonds and money-market obligations have been joined by a long and diverse roster of new obligations, many of them extraordinarily complicated. Along with the arcane tranches of mortgages that recently garnered attention are a myriad of financial derivatives, ranging from those traded on exchanges to tailor-made products for the over-the-counter market.

Leading financial institutions have grown rapidly as well. More importantly, they have evolved to become integrated, diversified, global enterprises that bear little resemblance to traditional commercial banks, investment banks or insurance companies. As these giants grow and dominate the market, they carry enormous potential for conflicts of interest -- they simultaneously act as investors of their own massive assets and as dealmakers and consultants on behalf of their clients. And their reach into the financial system is so broad and deep that no central bank is willing to allow the collapse of one of these leviathans. They are deemed "too big to fail."

These structural and institutional changes have, in turn, encouraged a new understanding among market participants of liquidity. In the decades that followed World War II, liquidity was by and large an asset-based concept. For business corporations, it meant the size of cash and very liquid assets, the maturity of receivables, the turnover of inventory, and the relationship of these assets to total liabilities. For households, liquidity primarily meant the maturity of financial assets being held for contingencies along with funds that reliably would be available later in life. In contrast, firms and households today often blur the distinction between liquidity and credit availability. When thinking about liquid assets, present and future, it is now commonplace to think in terms of access to liabilities.

This new mindset has been abetted by the tidal wave of securitization -- the conversion of nonmarketable assets into marketable assets -- that swept across the financial world in recent decades. This flood of marketable assets not only has eroded traditional concepts of liquidity, it has stimulated risk appetites and fostered a belief that credit usually is available at reasonable prices.

Technological change also has bolstered the easy-credit outlook now commonplace among investors. As markets have been linked globally by information technology networks, financial information flows nearly instantaneously, computerized trading is spreading, and transactions are executed almost without delay. Investors can access financial data and participate in markets around the world and around the clock.

These two developments -- securitization and the seamless interconnectivity of markets -- have brought intricate quantitative risk modeling to the forefront of financial practices. Securitization generates market prices, while information technology offers the power to quantify pricing and risk relationships. Few recognize, however, that such modeling assumes constancy in market fundamentals. This is because modeling does not adequately account for underlying structural changes when attempting to calculate future risks and prices.

Nor can models take into account the impact of growing financial concentration in the making of markets and in the pricing of securities that are traded infrequently, or that have tailor-made attributes. And what about the risks to financial markets of a major military flare-up, the ravages of a pandemic flu, a terrorist attack that would immobilize computer networks, or even shifts in the broader monetary environment? Do the models quantify these and other profound risks in any meaningful way?

Then there is the question of asset pricing. An essential component of successful risk modeling is accurate pricing of the securities used in the analysis. Here, again, the strictly quantitative approach shows its weaknesses. Accurate pricing is a thorny challenge. In rapidly moving markets, the price of the last trade may be invalid for the next one. The price a dealer is prepared to quote may be no more than an indication of a potential trade. And the price quoted may be valid only for a small quantity of assets, not for the full amount in the investor's portfolio.

These problems are especially germane to securities of lower credit quality, where liquidity and marketability are often blurred in the mark-to-market process. Again, the subprime mortgage crisis is revealing: Quantitative modeling proved to work poorly in pricing those lower-quality assets. We can expect major problems of this kind in the below-investment-grade corporate bond market once corporate profits begin to decline.

Risk modeling -- with its clear-cut timeline and aura of certainty -- has encouraged investors to seek near-term profits while pushing aside more qualitative approaches to risk assessment that rely more heavily on judgment and reason. The appetite for near-term profits showed itself plainly in the environment leading up to the subprime mortgage debacle -- leading financial institutions were unwilling to pull back from aggressive lending and investing tactics. To do so, they feared, posed a number of risks, from loss of market share and underperforming earnings to shareholder discontent and a failure to meet the bonus expectations of employees.

The Federal Reserve cannot walk away from its responsibility to limit financial excesses. The central tenet of monetary policy is to achieve sustainable economic growth. Central bank policies and actions attempt to do this by providing just enough reserves to constrain the price of goods and services at acceptably low levels. But how can the Fed achieve this objective when widespread financial excesses are disrupting the functioning of financial markets and thus threatening economic prosperity?

At the heart of the long-term underlying challenges that face the U.S. financial system is the question of how to enforce discipline. One way is to let competitive forces discipline market participants: The manager who performs well prospers, while those who do not fail. This is the central precept of free market economies. But this approach is compromised by the fact that advanced societies typically do not allow the process to follow through when it comes to very large financial institutions. The fear is that the failure of behemoth financial institutions will pose systemic risks both here and abroad.

Therefore, market discipline falls more heavily on smaller institutions, which in turn motivates them to merge into larger entities protected by the too-big-to-fail umbrella. This dynamic has driven financial concentration and will continue to do so for years to come. As financial concentration increases, it will undermine marketability, trading activity and effective allocation of financial resources.

If competition is not allowed to enforce market discipline, the most viable alternative is increased supervision over financial institutions and markets. In today's markets, there is hardly a clarion call for such measures. On the contrary, the markets oppose it, and politicians voice little if any support. For their part, central bankers do not possess a clear vision of how to proceed toward more effective financial supervision. Their current, circumspect approach seems objectively technical, whereas greater intervention, they fear, would seem intrusive, subjective, even excessive.

What is missing today is a comprehensive framework that pulls together financial-market behavior and economic behavior. The study of economics and finance has become highly specialized and compartmentalized within the academic community. This is, of course, another reflection of the increasingly specialized demands of our complex civilization. Regrettably, today's economics and finance professions have produced no minds with the analytical reach of Adam Smith, John Maynard Keynes or Milton Friedman.

It is therefore urgent that the Fed take the lead in formulating a monetary policy approach that strikes the right balance between market discipline and government regulation. Until it does so, we will continue to see shocks of even greater intensity than the one now radiating outward from the quake in the U.S. subprime mortgage market.

Mr. Kaufman is president of Henry Kaufman & Company, Inc., and the author of "On Money and Markets: A Wall Street Memoir" (McGraw-Hill, 2000).WSJ

Earlier this year the cover of Time Magazine depicted Ronald Reagan with a tear running down his cheek -- the message being that the political class has abandoned the Reagan legacy. There's no doubt Reagan's pro-growth, tax cutting philosophy is in full-scale retreat: This Congress has proposed higher tax rates on personal income, capital gains and dividends. Ironically, the Reagan economic philosophy of lower taxes, less regulation and free trade has never been more in vogue abroad -- so much so that it has become the global economic operating system.

Let's call this phenomenon Reaganomics 2.0.

In the Pacific Rim nations, for example, Malaysia, New Zealand, Singapore, Taiwan and Vietnam all have cut taxes this year or have plans to do so. Singapore has cut taxes multiple times in recent years and it now operates with no capital gains tax.

But the remarkable attitudinal shift on taxes has been in Europe, which in the 1980s and '90s showcased their gold-plated social safety nets, boasted of their citizens' willingness to pay high tax rates to maintain them and were openly contemptuous of the Reagan tax-cutting philosophy. Now those same nations of old-Europe seem to be in a sprint to see which country can get their tax rates lowest quickest. Nicholas Vardy, the editor of "The Global Guru" economic newsletter calls the phenomenon "Europe's Reagan Revolution."

French President Nicolas Sarkozy has plans to cut his country's business income tax by at least five percentage points as part of his economic rehabilitation plan. Spain and Italy are negotiating plans to lower their corporate tax rates, and the U.K. already did so earlier this year. Sweden and Russia last year eliminated their estate taxes because they said the tax was economically counterproductive. In Germany under Chancellor Angela Merkel, the corporate tax rate has been reduced to less than 30% from 39%.

Some of this tax chopping in Old Europe is a response to the success of the U.S. tax rate reductions and the fast pace of job creation that ensued from economic growth -- though few European officials will acknowledge that reality. But a bigger factor more recently has been the impact of the flat-tax revolution in Eastern Europe. Dan Mitchell of the Cato Institute says there are now 14 nations with flat taxes, 10 of them in nations formerly behind the Iron Curtain. "The pace of tax reform in these nations is so frantic, that it's hard to keep up to date with the changes," he says. Poland hasn't yet established a flat tax, but recently cut its business tax to 19% from 27%.

Austria cut its corporate tax rate to keep pace with its neighbor, Slovakia which recently adopted an 18% flat tax. Singapore is cutting taxes to compete with its 16% flat-tax rival Hong Kong. Northern Ireland wants to cut its tax rates so that it can compete with the economic gazelle of Europe, the Republic of Ireland. In 1988 Ireland was a high-unemployment stagnant economy with a 48% corporate tax rate, today that rate is 12.5% and the rest of the world is now desperate to match its economic results. Meanwhile German Finance Minister Peer Steinbrueck sold the latest tax cuts as "an investment in Germany as a business location."

The idea that jobs, businesses and wealth follow low tax rates is widely accepted. Nguyen Van Ninh, head of the Department of Taxation in Vietnam is typical. He concedes that the corporate tax cuts may lose revenues, but "on the other side, the business environment will become more and more attractive, resulting in increased investment."

This is all very good news -- except in the U.S. Arthur Laffer, one of the architects of the Reagan tax policies, believes that one major explanation for the strength of the euro and the weakness of the dollar in recent years, is the divergent paths on tax policies on the two sides of the Atlantic. Europe is cutting levies, while the only debate among the political class in Washington is how high to jack them up.

Still, it is a testament to the Reagan economic revolution launched in 1981 that, a quarter century later, global tax rates are 25 percentage points lower on average today than in the 1970s. And those figures don't even include this latest round of chopping under Reaganomics 2.0. The enactment of supply-side policies is helping ignite one of the strongest and longest world-wide economic expansions in history. Yet few are giving Reagan or his ideas the credit. Mr. Vardy points out that there are only two official statues of Reagan in Europe. Last month the Poles unveiled one financed by an American entrepreneur. The first was erected in Budapest to commemorate Reagan's "tear down this wall" speech in Berlin. Now tax walls are being torn down.

Alas, there's only about one place on the planet where politicians hold Reaganomics in outright disrepute today -- and that is here. The Democratic leadership in Congress believes that tax rates don't matter much if at all, and that the Bush tax cuts were a giveaway to the rich. Presidential candidate John Edwards has even suggested a near doubling of the U.S. capital gains tax rate as part of his economic program, and his rivals all have schemes to soak the wealthy as well.

All of this threatens to move America from leader to laggard in the global race for job creation, capital investment and prosperity. Maybe that explains the tear rolling down the Gipper's cheek.

August 27, 2007Executive Summary: How Poor Are America's Poor? Examining the "Plague" of Poverty in Americaby Robert E. RectorExecutive Summary #2064

Each year, the U.S. Census Bureau counts the number of "poor" persons in the U.S. In 2005, the Bureau found 37 million "poor" Americans. Presi dential candidate John Edwards claims that these 37 million Americans currently "struggle with incredible poverty."[1] Edwards asserts that America's poor, who number "one in eight of us…do not have enough money for the food, shelter, and clothing they need," and are forced to live in "terrible" cir cumstances.[2] However, an examination of the living standards of the 37 million persons, whom the government defines as "poor," reveals that what Edwards calls "the plague"[3] of American poverty might not be as "terrible" or "incredible" as candi date Edwards contends.

But, if poverty means (as Edwards asserts) a lack of nutritious food, adequate warm housing, and clothing for a family, then very few of the 37 million people identified as living "in poverty" by the Cen sus Bureau would, in fact, be characterized as poor. Clearly, material hardship does exist in the United States, but it is quite restricted in scope and severity.

The average "poor" person, as defined by the government, has a living standard far higher than the public imagines. The following are facts about persons defined as "poor" by the Census Bureau, taken from various government reports:

Forty-three percent of all poor households actu ally own their own homes. The average home owned by persons classified as poor by the Cen sus Bureau is a three-bedroom house with one-and-a-half baths, a garage, and a porch or patio.

Eighty percent of poor households have air conditioning. By contrast, in 1970, only 36 percent of the entire U.S. population enjoyed air conditioning.

Only 6 percent of poor households are over crowded; two-thirds have more than two rooms per person.

The typical poor American has more living space than the average individual living in Paris, Lon don, Vienna, Athens, and other cities throughout Europe. (These comparisons are to the averagecitizens in foreign countries, not to those classi fied as poor.)

Nearly three-quarters of poor households own a car; 31 percent own two or more cars.

Ninety-seven percent of poor households have a color television; over half own two or more color televisions.

Seventy-eight percent have a VCR or DVD player; 62 percent have cable or satellite TV reception.

Eighty-nine percent own microwave ovens, more than half have a stereo, and a more than a third have an automatic dishwasher.Overall, the typical American defined as poor by the government has a car, air conditioning, a refrig erator, a stove, a clothes washer and dryer, and a microwave. He has two color televisions, cable or satellite TV reception, a VCR or DVD player, and a stereo. He is able to obtain medical care. His home is in good repair and is not overcrowded. By his own report, his family is not hungry, and he had suf ficient funds in the past year to meet his family's essential needs. While this individual's life is not opulent, it is equally far from the popular images of dire poverty conveyed by the press, liberal activists, and politicians.

Of course, the living conditions of the average poor American should not be taken as representing all of the nation's poor: There is a wide range of liv ing conditions among the poor. A third of "poor" households have both cell and landline telephones. A third also have telephone answering machines. At the other extreme, approximately one-tenth of fam ilies in poverty have no telephone at all. Similarly, while the majority of poor households do not expe rience significant material problems, roughly a third do experience at least one problem such as over crowding, temporary hunger, or difficulty getting medical care.

Much poverty that does exist in the United States can be reduced, particularly among children. There are two main reasons that American children are poor: Their parents don't work much, and their fathers are absent from the home.

In both good and bad economic environments, the typical American poor family with children is supported by only 800 hours of work during a year—the equivalent of 16 hours of work per week. If work in each family were raised to 2,000 hours per year—the equivalent of one adult working 40 hours per week throughout the year—nearly 75 percent of poor children would be lifted out of offi cial poverty.

As noted above, father absence is another major cause of child poverty. Nearly two-thirds of poor children reside in single-parent homes; each year, an additional 1.5 million children are born out of wedlock. If poor mothers married the fathers of their children, nearly three-quarters of the nation's impoverished youth would immediately be lifted out of poverty.

Yet, although work and marriage are reliable lad ders out of poverty, the welfare system perversely remains hostile to both. Major programs such as food stamps, public housing, and Medicaid con tinue to reward idleness and penalize marriage. If welfare could be turned around to encourage work and marriage, the nation's remaining poverty could be reduced.

While renewed welfare reform can help to reduce poverty, such efforts will be partially offset by the poverty-boosting impact of the nation's immigration system. Each year, the U.S. imports, through both legal and illegal immigration, hun dreds of thousands of additional poor persons from abroad. As a result, one-quarter of all poor persons in the U.S. are now first-generation immigrants or the minor children of those immigrants. Roughly one in ten of the persons counted among the poor by the Census Bureau is either an illegal immigrant or the minor child of an illegal. As long as the present steady flow of poverty-prone persons from foreign countries continues, efforts to reduce the total number of poor in the U.S. will be far more dif ficult. A sound anti-poverty strategy must seek to increase work and marriage, reduce illegal immigra tion, and increase the skill level of future legal immigrants.

Robert Rector is Senior Research Fellow in Domestic Policy Studies at The Heritage Foundation.

Licensed to KillSeptember 10, 2007; Page A14Butchers, bakers and candlestick makers should enjoy their freedom while it lasts. These lucky professions have so far managed to stay off the list of livelihoods that now require a license to practice in any number of states. Taxidermists, massage therapists and interior decorators aren't so fortunate: They're among the professionals who must have their skills validated by the government.

Overall, the level of licensing regulation in the workplace is rising precipitously, with more than 20% of the workforce now required to get a permit to do their jobs -- up from 4.5% in the 1950s. This is the alarming finding of a new study by Adam Summers for the Reason Foundation. These requirements are essentially barriers to business entry and job creation, and Mr. Summers notes that they have become a greater obstacle to employment than minimum wage laws and labor unions.

With a total of more than 1,000 occupations now controlling entry, the numbers break down much as you might expect, providing a good reflection of state regulatory climates. With the exception of California, Eastern states are more regulated than Western states with their vestiges of the frontier mentality. Ditto states that usually show up as red on an election map: Republican leaners typically have fewer professional licensing barriers than their blue-state counterparts.

Some professional licensing may be a defensive outgrowth of the lawsuit culture, as business owners seek protection against, say, customers irate over how their haircuts turned out. But most is pushed by businesses for the age-old reason of restricting competition. This summer, in the wake of recent troubles in California's housing market, a legislator began calling for mandatory licensing for mobile home dealers. With a coming boom in foreclosures and resales, that must suit the existing big players just fine.

But even as one silly new credential is erected, others are being challenged. One Californian is suing the state for requiring him to spend two years studying to get a license to install spikes that deter pigeons from nesting. This, despite the fact that the plaintiff is already the holder of five state pest-control licenses. His case went before the Ninth Circuit Court of Appeals last month, where the government's own witnesses acknowledged that the law is irrational and intended to make it harder for new competitors to qualify. That's the kind of restraint on trade that the Federal Trade Commission ought to be worrying about instead of attacking successful supermarket chains.

The government's role in protecting the public from fraud may argue in favor of licensing in some very specialized, learned professions. A doctor or lawyer clearly needs a certified level of expertise. But even these professions sometimes attempt to create their own guild monopolies, such as when lawyers lobby to bar non-lawyers from assisting the public with such routine legal tasks as writing wills. It's even harder to see public benefit when similar rigorous oversight is applied to people who want to catch a reptile in Michigan, serve as a tribal rainmaker in Arizona, or be a fortune-teller in Maryland. That's right; it takes a license to predict the future in Baltimore, which we doubt leads to a better forecasting record.

Thanks to the Reason study, we now know how far the pendulum has swung in favor of these nasty little exercises in domestic protectionism.WSJ

Below is an essay found on the Fraser Institute web site. The Fraser Institute is an independent research and educational organization with offices in Vancouver, Calgary and Toronto. Our mission is to measure, study, and communicate the impact of competitive markets and government intervention on the welfare of individuals. Enjoy

Simple coincidence cannot explain that the first known patent was issued not just in the birthplace of the Italian Renaissance, Florence, but also roughly at the moment of its birth (1421). What is most intriguing about the issuance of patent No. 1 to Filippo Brunelleschi, who had invented a loading crane for ships, is less that the Florentine authorities granted it, and more that Filippo had asked for it in the first place. The preamble to this first patent states: “he refuses to make such machine available to the public, in order that the fruit of his genius and skill may not be reaped by another without his will and consent; and that, if he enjoyed some prerogative concerning this, he would open up what he is hiding, and would disclose it to all.”1 For 20 generations, medieval artisans had devised the means to build ever more complex cathedrals and public works and, yet, we know the names of only a handful of them. Why, then, against all tradition, did one man in 1421 stand up to demand both recognition of, and financial control over “his genius and skill”? The answer encompasses both changes to economic life and to the way people viewed themselves in society. In part, Filippo wanted control over his invention because economic changes had suddenly made it valuable beyond historical precedent. In the early fifteenth century, Florence had not only secured access to the markets of Constantinople and Cairo, but also had developed rudimentary banking and insurance skills which spurred a dramatic increase in trade. Still, the middle ages had witnessed the invention of the stirrup, the windmill, and the flying buttress without ever making an inventor wealthy. Perhaps more significantly, this obsessively commercial Italian city-state had incubated a view of people as no longer simply anonymous souls in an organic, hierarchical society held together by bonds of piety and obligation. Though argued to be classically-inspired, this singlatore uomo emerged as a new person in history, an active, self-directed agent in an expressive, creative and possessive society, in short, an individual in the world as it is, not as it should be. The very idea of a patent broke tradition with the norm of outright seizure. Florence’s rulers probably devised it as a trial-and-error response to an individual who had unexpectedly redefined what he could possess in and of himself at a time when the city was striving hard to improve its reputation vis ŕ vis Venice as a safer and more profitable venue for the Eastern trade. Not to be outdone, Venice, itself, soon ran patent contests offering winners even more favourable terms. If, for the city fathers of Florence and Venice (and shortly thereafter the German and Dutch trade cities), the granting of a patent was simply a calculation of costs and benefits, for Filippo, and the inventive individuals who followed him, it was a revolution in their economic and legal relationship to both the state and the broader business community. They held a property right, if only temporarily protected, to the relatively exclusive use and control of the physical and practical forms derived from their own unique insights into the possibilities of matter. What they owned the state could not seize, nor competitors steal. Thus, from its beginning, the patent embodied, in the words of Michael P. Ryan, “the philosophical tension between natural property rights and public welfare—enhancing incentives for risky investment.”2 One could, indeed, write the history of patent law as the shifting relative value of personal property rights versus a mere incentive for innovation and investment. Deputies of the National Assembly during the French Revolution asserted that an inventor’s property right in his or her discovery represented one of the “rights of man.” They desired in part to restrict the state and the aristocrats who controlled it from exploiting productive and innovative members of the bourgeoisie. In contrast, Thomas Jefferson, who worried less about aristocrats and more about the social value of proprietary knowledge, wrote Article I, section 8, of the Constitution to establish patents for strictly utilitarian purposes; in his words, “to promote the progress of Science and the useful Arts.”3 In the years since, fierce debates have broken out over whether intellectual innovations ought to be governed by property rights or by the utility of government’s either granting or removing monopoly privileges. One could conclude that personal interests will forever determine the debate. On the one side, inventors and their lawyers insist that intellectual property rights are about preventing theft. On the other, politicians and economic planners assert that patent “law” concerns the balance between industrial incentives and the diffusion of useful knowledge. But just as the Renaissance created “new facts” as to the nature of capitalism and to the nature of mankind, thus altering profoundly the treatment of innovation, so, too, will the next 20 years re-shape our thinking of intellectual property protection, tipping the balance farther towards a property-rights based conception of intellectual property. The impetus, the “new facts,” lies beyond the obvious—an economy increasingly driven by technological advances and thus more heavily dependent on proprietary knowledge, be it in the new (computers and software), or the traditional (medicine and agriculture). This greater dependence on intellectual property is not changing the nature of modern capitalism, but rather allowing it to operate at a qualitatively higher level of efficiency. New communication tools have sped the diffusion of both market information and production, thus speeding up the articulation of consumer preferences and the ability of producers to respond. It is no longer necessary to have either a central market or a central factory. Technology has simplified and automated monitoring and process functions, thus reducing both transaction costs and personnel costs relative to a unit of economic output. Technology has allowed us to become more productive, while at the same time subjecting us to fewer hierarchical and personal controls. Just as the innovations of banking and insurance awoke Florence to the possibilities of early capitalism, the greater economic role of intellectual property has brought into clearer focus Friederich Hayek’s vision of “extended order” through the “rule of law.”4 As entrepreneurs flourish and more individuals work for themselves (roughly one in six North Americans), the concept of productive work in a capitalist economy has embraced new, decentralized configurations. Work can be self-directed. High levels of economic activity can be sustained by networks of self-contracting individuals and not just by economies-of-scale corporations. This emergent free-agent capitalism will, in turn, give greater weight to the insight of Austrian economics—that our “producer surplus” lies less in the hours of our labour and more in our creativity.5 In time, this understanding should further strengthen and extend to intellectual property John Locke’s familiar argument that individuals own their labours, at least initially.6 If the value of our labour lies in the product of our minds, we have no less a right to own it than the product of our physical labour, regardless of the social cost. If anything, the argument for the personal possession of intellectual creativity is stronger than for physical labour because the former is by definition unique. As such, it remains outside the purview of the state and society until we choose to share it. Though collective rules may define the limits of possession, they should still respect the origins of possession. It would be insufficient to argue circularly that the current highly productive use of “owned” knowledge (patents) proves the case that property law, not policy wishes, guide decision-makers. Just as in the Renaissance, economic opportunity is alone an incomplete force to change attitudes. As in the fifteenth century, the legal recognition of intellectual property arose in response to both a new form of economic organization and to a new sense not just of self, but of its abstraction—the individual. If we are not surprised today that the nature of the economy is in flux, neither should we be if our ideas of the individual are shifting. At least, Western history shows individualism to possess an ontology or a story of change.7 This cannot help but alter the cultural boundaries into which we cast the nature and treatment of innovation and innovators. After all, it was a champion of the individual, not of economics, Lysander Spooner, the nineteenth century libertarian, who first coined the potent phrase, “intellectual property,” recasting unalterably the debate.8 Will our society, in the new millennium, recognize even greater individual autonomy, thus further shielding intellectual property from the short-term utilitarian machinations of a politicized state? It should, but wishes are poor predictions. Still, if the hard-edged men of Renaissance Florence could figure out the advantage of patents in the first place, perhaps we can discern the potential value of conceiving of intellectual property as individual property before the law. In the real world, full of Filippo Brunschellis and Bill Gateses, the power of these individuals’ imaginations may illuminate a social self-interest expanding our current definitions of collective utility. The future of individualism, intellectual property, and capitalism should not be bound by today’s crude efforts to measure and analyze them. Notes 1Bruce W. Bugbee, Genesis of American Patent and Copyright Law (Washington: Public Affairs Press, 1967), p. 17. 2Michael P. Ryan, Knowledge Diplomacy: Global Competition and the Politics of Intellectual Property (Washington: Brookings Inst. Press, 1998), p. 7. 3Tom Bethell, The Noblest Triumph: Property and Prosperity through the Ages (New York: St. Martin’s Press, 1998), p. 262.

The Fed and CharacterSeptember 19, 2007; Page A20The Federal Reserve pulled no punches yesterday with its decision to cut the fed funds rate by 50 basis points to 4.75%. The unanimous statement from the Fed's Open Market Committee was equally as definitive, leaning clearly on the side of those willing to risk more inflation in order to protect the economy from recent disruptions in the credit markets.

The equity markets rejoiced, posting their biggest daily gain of the year. Inflation-sensitive indicators were less thrilled, with the yield on the long (30-year) bond rising 26/32s to 4.75%, oil climbing above $82 a barrel, and gold reaching new heights at $733 an ounce. In the optimistic case, the Fed's move will ease the credit crisis, increase the demand for money by reviving economic confidence, and help avoid a recession without triggering more inflation. We can only hope it does.

The point we'd like to stress today concerns the Fed and its credibility -- or to put it more tartly, its character. It is easy for a central bank to cut rates and ease money. At least in the short term everybody loves a good time, as yesterday's equity euphoria showed. The harder task is being willing to tighten money amid the business and political criticism that inevitably follows. That's the true test of a central banker's mettle.

We've argued that the Fed hasn't shown that character in many years, which is a major reason it found itself this week having to choose between the risk of higher inflation and a potential recession. A central bank that stresses preserving the value of the currency when it isn't popular will have more credibility to ease money when it really needs to.

This is the abiding lesson of the Paul Volcker era at the Fed, in contrast to the current decade. As Chairman Ben Bernanke looks beyond today's crisis to what he wants his own legacy to be, we hope he'll make a restoration of the Fed's character his main priority.

From my point of view, I hold economists to a much lower standard than their ability to see the future - I am happy if they can just explain the past with some degree of accuracy. For example, I am interested in a plausible explanation of how we got to these new relative values for competing currencies.

It's time to start taking seriously the proposition that the American economy under the Bush administration is the best in the nation's history. This morning the White House expressed entirely appropriate pride in the country's economic achievements on its watch:

Today, the Bureau of Labor Statistics released new jobs figures – 110,000 jobs created in September. September 2007 is the 49th consecutive month of job growth, setting a new record for the longest uninterrupted expansion of the U.S. labor market. Significant upward revisions to employment in July and August mean employment growth has averaged 97,000 per month over the last three months. Since August 2003, our economy has created more than 8.1 million jobs, and the unemployment rate remains low at 4.7 percent.

Real after-tax per capita personal income has increased by over 12.5 percent – an average of over $3,750 per person – since President Bush took office. More than 30 percent of the Nation's net worth has been added since the President's 2003 tax cuts.

Real wages have grown 2.2 percent over the 12 months that ended in August. This is much higher than the average growth rate during the 1990s, and it means an extra $1,266 in the past year for a family with two average wage earners.

Real GDP grew at a strong 3.8 percent annual rate in the second quarter of 2007. The economy has now experienced nearly six years of uninterrupted growth, averaging 2.7 percent a year since the turnaround in 2001.

The stock market is at record highs, unemployment continues at historic lows. What's not to like? Of course, one can always question the link between prosperity (or the lack thereof) and government policies. But in President Bush's case, it seems pretty obvious that his tax cuts prevented what could have been a disastrous downward spiral. At a time when our economy was subject to the double-whammy of recession and the bursting of the tech bubble, the terrorist attacks of September 11, 2001 could easily have sent the economy into a tailspin.

By the same token, I don't think any serious observer doubts that the policies the Democrats want to adopt will damage the economy. The Democrats want higher taxes:

If Congress lets Bush's tax cuts expire, it would increase taxes by more than $1,800, on the average, for a family of four making $60,000 dollars a year. Small business owners would see their taxes go up by almost $4,000, and families with children would pay an additional $500 per child.

Beyond that, the adverse economic consequences of socialized medicine are incalculable. And we haven't mentioned what would happen if the federal government started mandating the shut-down of industry so as to reduce carbon emissions in a superstitious attempt to control the weather, while China and India do nothing of the sort.

I became a Republican mostly because experience and observation taught me that free enterprise works, and socialism doesn't. Those issues have been more or less off the table in recent years because of the downfall of international socialism, the relatively enterprise-friendly Clinton administration and the Republicans' failure to control spending while they controlled Congress. But the economic issues may be about to emerge once again, as Americans consider whether they want to abandon the successful policies of the Bush administration.

As far as economic recoveries go, the current one may be the most maligned in history. One glaring weakness, which pessimists never tire of pointing out, is that payroll job growth in this cycle has been weaker than in the 1990s. Over the past three years, payroll jobs have grown at an average monthly rate of 180,000. At the same point in the previous cycle (1994-96) payrolls grew at an average monthly rate of 244,000.

But don't despair. While the data is accurate, it is highly misleading. After digging beneath the surface, the jobs market is just as strong today as it was in the mid-1990s.

First, the unemployment rate was higher in 1994 than it was in 2004, 6.6% versus 5.4%. As a result, pent up demand for labor in the 1990s helped lift job growth.

Second, there has been a massive decline in young people who want a job. Without the drop among 16-24 year olds, a higher share of the population would be participating in the labor force today than a decade ago.

Notably, most of the drop in labor force participation among the young is due to increased school enrollment. Not only do students work less than non-students, but today's students are working less than their predecessors. About 44% of teenage students were in the labor force in the mid- 1990s versus about 36% in the past few years. In our view, this is a sign of prosperity and suggests support for productivity growth in the future once these more educated workers eventually get a job.

Third, Baby Boomers were in their peak working years in the 1990s and are now moving toward retirement. Labor force participation tends to peak at about age 40 and declines rapidly after age 50. In the mid-1990s the typical Baby Boomer was about age 40 and none of them were older than 50. Now, about half of Boomers have passed age 50.

Last, the Labor Department uses two major surveys for job creation. The establishment survey asks businesses how many are on their payrolls. That's the source of the payroll data, which has been weak relative to the 1990s. The household survey asks people directly if they are working. This survey generates data on civilian employment, which has increased at an average monthly rate of 189,000 in the past three years, almost exactly the 191,000 rate in 1994-96.

If someone has two jobs, the payroll data counts them twice, while the household survey does not. In the 1990s, the number of workers holding multiple jobs was rising, which boosted the payroll data relative to the household data. Lately, the number of these multiple job holders has fallen, helping move the two surveys back in line. Clearly, this suggests that the 2000s may actually have a healthier job market than the 1990s. This view is buttressed by the fact that in the past two years average hourly earnings are up 8.4, the fastest pace since 1990.

Given all these important demographic changes, payroll growth has actually been healthy, not weak. A useful analysis published last year by the Federal Reserve Bank of Kansas City suggests payrolls need to grow at an average monthly rate of about 120,000 to keep the unemployment rate steady. Looking back, payroll employment has grown at a 1.07% annual rate since March 1998, when the unemployment rate was also equal to today's 4.7%. Applying this rate of growth to the current level of payrolls suggests that the US needs 123,000 new payroll jobs every month to hold the unemployment rate steady.

A little digging is all it takes to show that the unfairly maligned economy is actually doing quite well. The good news is that all this concern creates a â€śwall of worryâ€ť that the stock market continues to climb.

Thanks for this Doug. Wesbury is an outstanding economist, with a true gift for conceptualizing in a way that both simplifies and gets to the essence. His track record as a prognosticator is one of the very best out there.

Since I haven't found anyone here so far to argue against free market based economics, I'll post the opposing view myself, courtesy of the NY Times. They contend we are severely under-taxed. Absolutely no hint in their 'analysis' that revenues to the treasury are actually growing at record rates. Only 'logic' I could find to back their view is that America needs to be more like the rest of the world, starting with tax burden. Their math with a 28% total tax burden doesn't exactly match tax freedom day that occurs here in May. Nonetheless, our "meager tax take" of 4 trillion dollars per year"leaves the United States ill prepared to compete."

President Bush considers himself a champion tax cutter, but all the leading Republican presidential candidates are eager to outdo him. Their zeal is misguided. This country’s meager tax take puts its economic prospects at risk and leaves the government ill equipped to face the challenges from globalization.

According to a report from the Organization of Economic Cooperation and Development, a think tank run by the industrialized countries, the taxes collected last year by federal, state and local governments in the United States amounted to 28.2 percent of gross domestic product. That rate was one of the lowest among wealthy countries — about five percentage points of G.D.P. lower than Canada’s, and more than eight points lower than New Zealand’s. And Danes, Germans and Slovaks paid more in taxes, as a share of their economies.

Politicians on the right have continuously paraded the specter of statism to rally voters’ support for tax cuts, mainly for the rich. But the meager tax take leaves the United States ill prepared to compete. From universal health insurance to decent unemployment insurance, other rich nations provide their citizens benefits that the United States government simply cannot afford.

The consequences include some 47 million Americans without health insurance and companies like General Motors being dragged to the brink by the cost of providing workers and pensioners with medical care.

President Bush and his tax-averse friends extol the fact that the tax haul has risen over the past two years as evidence of the wisdom of his tax cuts. But if anything, the numbers underscore the economy’s weaknesses — mainly its growing inequality.

Indeed, the growth in tax revenue since 2004 is due mostly to the spectacular increase in corporate profits, which have grown at the expense of workers’ wages. Moreover, it’s proving ephemeral. As economic growth has decelerated, corporate profits are losing steam and the growth of tax revenue has begun to slow. This pretty much guarantees that the revenue will prove too low to face the challenges ahead.

Dollar BenNovember 1, 2007; Page A18Watching the U.S. currency continue to decline in value, our irreverent friends at the New York Sun have stopped referring to the dollar. They now call it "the Bernanke," in mock honor of the Federal Reserve Chairman who is presiding over the greenback's plunge. With another rate cut yesterday, Ben Bernanke and the Fed are continuing to act as if they like the Sun's moniker.

At least this time the Fed accompanied its rate cut with a statement acknowledging that "some inflation risks remain" and that it will "act as needed to foster price stability" and economic growth. This time there was also a dissenter, with Kansas City Fed President Thomas Hoenig opposing the rate cut. Perhaps he's been paying attention to the super-rally in inflation-sensitive price signals since the Fed declared in September that it put a higher priority on limiting the housing recession than on the value of the currency.

Commodities have soared, including oil, which passed $94 a barrel yesterday; predictions of $100 oil are commonplace. Some politicians are blaming tensions with Iran for the oil spike, but those tensions have ebbed and flowed for several years. What has mostly flowed is the supply of dollars, and so some part of oil's increase should be called the Alan Greenspan-Ben Bernanke inflation premium. To the extent higher oil prices slow economic growth, they also defeat the stated purpose of the Fed's rate cuts.

The dollar price of gold is also reaching heights not seen since 1980, closing near $800 an ounce yesterday. Gold is not some magic talisman, but it has served throughout history as a reasonable proxy for other prices. The nearby chart shows the trend since 1971, and if nothing else the recent gold rally is a market commentary on the Fed's priorities. The speculators think the risk is all on the inflation side. Meanwhile, the dollar -- "the Bernanke" -- also hit a record low against the euro yesterday.

For the Fed and most of Wall Street, this is all worth any future inflation risk. The Fed is guarding against the danger that the recent credit-market turmoil will send the larger economy into a recession. The bankers holding bad mortgage assets are also cheering easier money, as they beg for a housing reflation so they don't have to take even larger write-offs. Then there are the exporters and economists who think the U.S. can devalue its way to prosperity, or at least to a few quarters of export-driven expansion until the housing market hits bottom.

Lost in all of this domestic focus is the fact that there are also major risks to the Fed's reflation. The Fed isn't merely a creature of U.S. policy but is the steward of the global financial system. The dollar is the world's reserve currency. It is vital as a medium of global trade and investment, and central banks hold hundreds of billions of dollars as reserves. Many countries peg their own currencies to the greenback, meaning that they are subcontracting their own monetary policies to the Fed. These countries import American inflation when the Fed makes a mistake.

All of which means the Fed has a special responsibility to avoid a disruption in the world monetary system. In particular, it needs to avoid the perception that it favors a devalued greenback for narrow domestic purposes, lest it signal to countries around the world that they can play the same game. The recent cry of concern over the dollar by Rodrigo Rato, the departing head of the International Monetary Fund, is a sign that the world is beginning to wonder.

In the worst case, the world could lose faith in U.S. monetary management and there would be a run on the dollar. Then the Fed would have no choice but to raise rates much higher and faster to restore its credibility, and the recession that followed would be far worse. That's what happened as recently as the 1970s, the last time gold and oil reached these heights and the dollar was this weak. In that era, as in this one, the excuse for easier money was always to save the U.S. economy from recession. In that era, too, the rise in oil prices, gold and other commodities was blamed on everything except monetary policy -- OPEC, or rising global demand or something.

We rehearse all this not to say we are back at the 1970s but as a warning that we can get there faster than the sages at the Fed imagine. Yesterday's report that third-quarter economic growth clocked in at 3.9%, following 3.8% in the second, already shows that most Wall Street forecasters were wrong earlier this year. The Fed is worried about growth after the summer credit implosion, to be sure. But if the economy defies the forecasters again, the Fed could be raising rates faster than it now expects. The dollar's credibility as the world's reserve currency may depend on it. WSJ

We live in a positive-sum world economy and have done so for about two centuries. This, I believe, is why democracy has become a political norm, empires have largely vanished, legal slavery and serfdom have disappeared and measures of well-being have risen almost everywhere. What then do I mean by a positive-sum economy? It is one in which everybody can become better off. It is one in which real incomes per head are able to rise indefinitely.

How long might such a world last, and what might happen if it ends? The debate on the connected issues of climate change and energy security raises these absolutely central questions. As I argued in a previous column ("Welcome to a world of runaway energy demand", November 14, 2007), fossilised sunlight and ideas have been the twin drivers of the world economy. So nothing less is at stake than the world we inhabit, by which I mean its political and economic, as well as physical, nature.

According to Angus Maddison, the economic historian, humanity's average real income per head has risen 10-fold since 1820.* Increases have also occurred almost everywhere, albeit to hugely divergent extents: US incomes per head have risen 23-fold and those of Africa merely four-fold. Moreover, huge improvements have happened, despite a more than six-fold increase in the world's population.

It is an astonishing story with hugely desirable consequences. Clever use of commercial energy has immeasurably increased the range of goods and services available. It has also substantially reduced both our own drudgery and our dependence on that of others. Serfs and slaves need no longer satisfy the appetites of narrow elites. Women need no longer devote their lives to the demands of domesticity. Consistent rises in real incomes per head have transformed our economic lives.

What is less widely understood is that they have also transformed politics. A zero-sum economy leads, inevitably, to repression at home and plunder abroad. In traditional agrarian societies the surpluses extracted from the vast majority of peasants supported the relatively luxurious lifestyles of military, bureaucratic and noble elites. The only way to increase the prosperity of an entire people was to steal from another one. Some peoples made almost a business out of such plunder: the Roman republic was one example; the nomads of the Eurasian steppes, who reached their apogee of success under Genghis Khan and his successors, were another. The European conquerors of the 16th to 18th centuries were, arguably, a third. In a world of stagnant living standards the gains of one group came at the expense of equal, if not still bigger, losses for others. This, then, was a world of savage repression and brutal predation.

The move to the positive-sum economy transformed all this fundamentally, albeit far more slowly than it might have done. It just took time for people to realise how much had changed. Democratic politics became increasingly workable because it was feasible for everybody to become steadily better off. People fight to keep what they have more fiercely than to obtain what they do not have. This is the "endowment effect". So, in the new positive-sum world, elites were willing to tolerate the enfranchisement of the masses. The fact that they no longer depended on forced labour made this shift easier still. Consensual politics, and so democracy, became the political norm.

Equally, a positive-sum global economy ought to end the permanent state of war that characterised the pre-modern world. In such an economy, internal development and external commerce offer better prospects for virtually everybody than does international conflict. While trade always offered the possibility of positive-sum exchange, as Adam Smith argued, the gains were small compared with what is offered today by the combination of peaceful internal development and expanding international trade. Unfortunately, it took almost two centuries after the "industrial revolution" for states to realise that neither war nor empire was a "game" worth playing.

Nuclear weapons and the rise of the developmental state have made war among great powers obsolete. It is no accident then that most of the conflicts on the planet have been civil wars in poor countries that had failed to build the domestic foundations of the positive-sum economy. But China and India have now achieved just that. Perhaps the most important single fact about the world we live in is that the leaderships of these two countries have staked their political legitimacy on domestic economic development and peaceful international commerce.

The age of the plunderer is past. Or is it? The biggest point about debates on climate change and energy supply is that they bring back the question of limits. If, for example, the entire planet emitted CO 2 at the rate the US does today, global emissions would be almost five times greater. The same, roughly speaking, is true of energy use per head. This is why climate change and energy security are such geopolitically significant issues. For if there are limits to emissions, there may also be limits to growth. But if there are indeed limits to growth, the political underpinnings of our world fall apart. Intense distributional conflicts must then re-emerge - indeed, they are already emerging - within and among countries.

The response of many, notably environmentalists and people with socialist leanings, is to welcome such conflicts. These, they believe, are the birth-pangs of a just global society. I strongly disagree. It is far more likely to be a step towards a world characterised by catastrophic conflict and brutal repression. This is why I sympathise with the hostile response of classical liberals and libertarians to the very notion of such limits, since they view them as the death-knell of any hopes for domestic freedom and peaceful foreign relations.

The optimists believe that economic growth can and will continue. The pessimists believe either that it will not do so or that it must not if we are to avoid the destruction of the environment. I think we have to try to marry what makes sense in these opposing visions. It is vital for hopes of peace and freedom that we sustain the positive-sum world economy. But it is no less vital to tackle the environmental and resource challenges the economy has thrown up. This is going to be hard. The condition for success is successful investment in human ingenuity. Without it, dark days will come. That has never been truer than it is today.

*Contours of the World Economy, 1-2030 AD, Oxford University Press 2007

The above post is basically saying that the prosperity that we have had is due to the positive growth economics theory. I have 2 comments about this.

1. There is evidence that our present unprecedented economic success is based not on the economic theory but the fact that we entered an age where we had started to use vast stores of oil as an energy source. Its not the theory that generated prosperity, its the presence of resources. If we imagine a day when someone works out a "magic" solution such as unlimited cheap energy (fusion or whatever) everyone everywhere would breath a sigh of relief

2. There is a recent article in Scientific American that points out that present economic theory was modeled after Helmhotz equations on the conservation of energy. In this article it basically reiterates the point that present day economic theory is flawed for not accounting for the impacts of resource extraction as part of the system. This seems to point a finger at positive growth economics.

I keep finding articles like this. Most of them come from people with training in both economics and science.

The 19th-century creators of neoclassical economics—the theory that now serves as the basis for coordinating activities in the global market system—are credited with transforming their field into a scientific discipline. But what is not widely known is that these now legendary economists—William Stanley Jevons, Léon Walras, Maria Edgeworth and Vilfredo Pareto—developed their theories by adapting equations from 19th-century physics that eventually became obsolete. Unfortunately, it is clear that neoclassical economics has also become outdated. The theory is based on unscientific assumptions that are hindering the implementation of viable economic solutions for global warming and other menacing environmental problems.The physical theory that the creators of neoclassical economics used as a template was conceived in response to the inability of Newtonian physics to account for the phenomena of heat, light and electricity. In 1847 German physicist Hermann von Helmholtz formulated the conservation of energy principle and postulated the existence of a field of conserved energy that fills all space and unifies these phenomena. Later in the century James Maxwell, Ludwig Boltzmann and other physicists devised better explanations for electromagnetism and thermodynamics, but in the meantime, the economists had borrowed and altered Helmholtz’s equations.

The strategy the economists used was as simple as it was absurd—they substituted economic variables for physical ones. Utility (a measure of economic well-being) took the place of energy; the sum of utility and expenditure replaced potential and kinetic energy. A number of well-known mathematicians and physicists told the economists that there was absolutely no basis for making these substitutions. But the economists ignored such criticisms and proceeded to claim that they had transformed their field of study into a rigorously mathematical scientific discipline.

Strangely enough, the origins of neoclassical economics in mid-19th century physics were forgotten. Subsequent generations of mainstream economists accepted the claim that this theory is scientific. These curious developments explain why the mathematical theories used by mainstream economists are predicated on the following unscientific assumptions:

The market system is a closed circular flow between production and consumption, with no inlets or outlets. Natural resources exist in a domain that is separate and distinct from a closed market system, and the economic value of these resources can be determined only by the dynamics that operate within this system. The costs of damage to the external natural environment by economic activities must be treated as costs that lie outside the closed market system or as costs that cannot be included in the pricing mechanisms that operate within the system. The external resources of nature are largely inexhaustible, and those that are not can be replaced by other resources or by technologies that minimize the use of the exhaustible resources or that rely on other resources. There are no biophysical limits to the growth of market systems. If the environmental crisis did not exist, the fact that neoclassical economic theory provides a coherent basis for managing economic activities in market systems could be viewed as sufficient justification for its widespread applications. But because the crisis does exist, this theory can no longer be regarded as useful even in pragmatic or utilitarian terms because it fails to meet what must now be viewed as a fundamental requirement of any economic theory—the extent to which this theory allows economic activities to be coordinated in environmentally responsible ways on a worldwide scale. Because neoclassical economics does not even acknowledge the costs of environmental problems and the limits to economic growth, it constitutes one of the greatest barriers to combating climate change and other threats to the planet. It is imperative that economists devise new theories that will take all the realities of our global system into account.

Thanks to Karsk for comments and the article. I disagree. I don't see a correlation between economic growth, wealth and the 'owning' of the natural resources in demand. For example, America largely leaves its oil in the ground and is the world's leading economy and the largest consumer of oil. Japan with virtually no natural resources built its wealth other ways, while places loaded with resources such as Brazil and Africa for example always seem to sputter. I think oil wealth in countries like Iraq, Saudi, Iran, Venezuela and Russia is a distraction from real wealth building activities, much like drug kingpins with the nicest cars in the ghetto are a distraction away from constructive, wealth-building activities.

I think positive growth is more a function of consistent public policies that are conducive to earn, save, own, invest, hire, etc.

A classic book that covers timeless economic principles, Ibn Khaldun's 'Muqaddimah' introduction to history (from 1377) is now published on the web at books.google.com

An economic excerpt in translation from the original arabic:

"In the early stages of the state, taxes are light in their incidence, but fetch in a large revenue...As time passes and kings succeed each other, they lose their tribal habits in favor of more civilized ones. Their needs and exigencies grow...owing to the luxury in which they have been brought up. Hence they impose fresh taxes on their subjects...[and] sharply raise the rate of old taxes to increase their yield...But the effects on business of this rise in taxation make themselves felt. For business men are soon discouraged by the comparison of their profits with the burden of their taxes...Consequently production falls off, and with it the yield of taxation."

The point of the article is that there is an upper limit to things sometimes. Its tempting to make some simplistic examples from ecology where real limits exist to make the point. Human beings are more complex in that they have always managed to innovate to take advantage of other resources. Nevertheless, I have always felt that there is a simple logic that we live in a world where matter is finite (there is only so much matter) and energy flows from concentrated to dispersed. The fact that we have finite resources has been less important than our capacity to be innovative up to now. But there is some population level where the capacity to innovate becomes less important than the genuine scarcity of materials or the inability of energy flow to keep up with the consumption. Are we there globally for some resources? I dunno. But I do know that their really are limits. The consequence of going past real limits is catastrophic change resulting in a resetting of the systems. Lots of people don't like that sort of change.

This is an aside, but one of the things that truly amazes me about people is their adaptability. We pride ourselves on being adaptable. I know I do. But not all forms of adaptation are good. At what population level does human existence become so base that people cannot stand it and implode? The scary thing to me is not that there is a point of degradation that people cannot stand. Its actually that people adapt to the extreme levels of environmental degradation that they do. The population density of large cities, the density of some third world countries....that is freaky that people can adapt. They adapt and adapt until they reach a point that is far beyond a sustainable carrying capacity and then blammo. I suppose you could say that thats mother nature for you and I think you would be correct. Is the only effective economics systems those that pretty much ignore limits until there are impacts that cause catastrophes or are there other more clever ways to manage things as pressures increase? How can you avoid periods of time where there are downturns? Is it possible or even desirable to try to avoid downturns forever? Are downturns natural and if so can we plan specifically for them? Can we plan for a 4 staged cycle of innovation and evolution, build up, stagnation, and collapse? An economic model that defines success as growth seems inconsistent with reality when viewed from an ecological perspective. When has growth continued anywhere unabated ever? I can think of no example where growth is not balanced by collapse in the natural world whenever resources are limiting. The complexities of economics and political machinations all function within that context don't they?

Personally I like low interest rates, but Wesbury explains clearly here IMO why we have problems now with the value of the dollar. At the conclusion I must quibble with him. The solution in 1980-83 included a two-prong pollicy, tighter money AND stimulative tax rate cuts. A tighter Fed today would not be linked with tax rate cuts, regulatory reform or anything else economically helpful so it certainly would dampen the growth rate of the economy. It's hard to correct suddenly for a decade of mistakes. (Cut and paste from a columned pda doesn't format very well.)

What's missing in most analysis isthe impact of inflationarymonetary policy. Since 2001, andespecially since September 2007 –when the Fed started cutting ratesin response to credit market issues– excessively easy monetarypolicy has driven oil and othercommodity prices through theroof.

The good news is we've been herebefore, and we know – well, atleast 1980s Fed Chairman PaulVolcker knows – how to get outof this mess. Loose money in the1960s and 1970s drove up theprice of everything. A barrel ofoil, which sold for $2.92 in 1965,rose to $40 in 1980. Most peoplebelieved that rising commodityprices indicated that the worldwas running out of resources. TheClub of Rome predicted globalruin, and then President JimmyCarter said that "peak oil" wasright around the corner.

Oklahoma-based Penn Square Bankhanded out oil loans freely, andsold off pieces of its loans inpackages called "participations."Seafirst Bank in Seattle andContinental Bank in Chicago weretwo good customers. These banksthought oil prices would remainelevated and paid a huge price fortheir mistake.

Money is the ultimate commoditybecause all prices have only moneyin common. And it is the only thingthat a central bank directly controls.Unfortunately, because ofglobalization and financial-marketinnovation, money itself hasbecome hard to measure anduseless as a forecasting tool. Soanalysts use interest rates.

The "natural rate of interest" is thetheoretical interest rate at whichmonetary policy does notartificially boost the economy, norhold it back. It is also the rate atwhich money is neutral oninflation. There have been manyattempts at measuring this. Someeconomists look at real interestrates. Others use the Taylor Rule,which includes a target rate forinflation and real growth.

And while these methods arehelpful, they rely on estimates. Idevised a much simpler systemback in 1993, based on actualeconomic data, that has provenextremely useful. It predicted thesharp increase in long-terminterest rates in 1994; it alsopredicted the recession of 2001,the deflation of the early 2000s,and the inflation of recent years.

This model shows that a neutralfederal funds rate should beroughly equal to nominal GDPgrowth. Nominal GDP growth(real growth plus inflation)measures total spending in theeconomy, or to put it anotherway, it reflects the averagegrowth rate for all companies inthe economy.

In 1980, then Fed ChairmanVolcker lifted the fed funds ratesignificantly above GDP growthand held it there long enough toend inflation. This policyinstigated a steep decline in oilprices, and drove a stake throughthe heart of stagflation.

Low inflation turned to deflationin 1999 and 2000, when the Fedmistakenly pushed the funds rateabove nominal GDP growthagain. This deflation spooked theFed and led to a radical reductionin interest rates. Since then, thefed funds rate has been wellbelow GDP growth – an averageof 210 basis points – the mostaccommodative six years ofmonetary policy since the 1970s.No wonder inflation is on the riseand commodity prices are settingnew records.

The Fed lifted the funds rate from1% to 5.25% between 2004 and2006, but monetary policy wasnever tight because the rate neverwent above nominal GDP. Thissuggests that housing marketproblems were not caused by tightmoney in 2006-07, but byexcessive investment during thesuper-easy money of the yearsbefore.

Nonetheless, the Fed opened up theold playbook and cut ratesaggressively when subprime loansblew up. This cemented higherinflation into place, crushed thedollar, pushed commodity prices upsharply, and created majorproblems in the energy, airline andagricultural marketplaces. And justlike the 1970s, it is now popular toargue that the world is running outof resources again.

The answer to all of this is for theFed to lift rates back to their naturalrate, which is somewhere north of5%. Tax-rate reductions andinterest-rate hikes cured the worldof its ills in the early 1980s. Theycan do so again.

I think you raise an interesting line of thought in your introdutory remarks to Wesbury's piece. Would you please flesh out the implications of the fact that the Reagan cuts were phased in over three years? IRRC, per supply side doctrine, the acutalization of many gains was deferred untill the third year, which, contrary to monetarist predictions, is when the Reagan boomed kicked off.

Crafty wrote:"Would you please flesh out the implications of the fact that the Reagan cuts were phased in over three years? IRRC, per supply side doctrine, the actualization of many gains was deferred until the third year, which, contrary to monetarist predictions, is when the Reagan boomed kicked off."

What you are getting at I think is that people don't accelerate their economic activity now when they know their income will be taxed at a better rate later.

As concisely as I can recap from memory:

We had horrible 'stagflation' coming into the Reagan election, simultaneous stagnation and inflation, defying all things Keynesian namely the Phillips curve which said that high unemployment meant low inflation and high inflation meant low unemployment. We had both out of control at the same time and called it the Misery Index.

Robert Mundell, now a Nobel winner and Professor at Columbia, wrote a two prong solution for a two prong problem. We needed tight money to control inflation and SIMULTANEOUS across the board marginal tax rate cuts to stimulate economic activity and correct what he called the "asphyxiating" tax rates that people grew into because of inflation-caused bracket creep. In other words, ordinary workers were being taxed at the punitive rates aimed at the rich and the rich were keeping their money out of productive uses to minimize taxes.

But the timing didn't work out that way. Reagan had to compromise with a reluctant congress led by the other party so the 30% tax cuts became 25% and were delayed and phased in over 3 years instead of immediately. Meanwhile the Fed cranked down hard on tight money right away - no delay, no phase-in. The result was a painful recession until the full effect of the tax cuts hit in the third year.

By 1984 the economy was hitting on all cylinders and inflation was largely gone. Candidate Mondale hated the tax cuts and promised to raise them. Reagan won 49 states.----That part you knew, so I have to add this piece from my Minnesota bias that most historians miss: the national confidence to elect Reagan, cut taxes, rebuild America and stand up to the Soviets started when some college kids that trained hard, went to Lake Placid NY, beat the Soviet hockey team and took the Olympic gold medal. Fighters should get the movie 'Miracle' and see the workout Herb Brooks put his team through after a disappointing tie with Norway on their path to the gold...

And good suggestion about the movie "Miracle". My son is getting involved in playing hockey and this could be a good movie for us to watch. To help me with my search, do you remember the name of the lead actors?

People these days fear inflation. We also fear changing rates of inflation. And most of the tools we might use to protect ourselves, such as the Treasury Inflation-Protected Securities bond or gold stocks, are imperfect. TIPS are, after all, based on an inflation-measure whose accuracy is itself controversial – the Consumer Price Index.

So it's worth remembering that, 75 years ago today, President Franklin D. Roosevelt destroyed an inflation hedge that was literally as good as gold: the so-called "gold clause." This helped prolong the Depression and has been causing damage ever since.

Consider an investor in the gold standard era. An ounce of gold was worth $20.67 and you could, at least in theory, trade your greenbacks for gold at the bank. The gold standard checked a government's willingness to inflate, since it started losing gold when it did so. Those who traded bonds knew a confidence we can never know.

Washington, like all governments, could occasionally cheat on the gold standard – suspend it, limit the ability of citizens to convert paper into gold, and so on. But investors could protect themselves by writing a gold clause into their contracts. Such a clause promised a borrower that he could be repaid "in gold coin of the United States of America of or equal to the present standard of weight and fineness." The gold clause fostered economic growth in the late 19th and early 20th centuries by making it easier for young industries to raise capital. Since investors protected by these clauses knew they would get their money back, interest rates were lower. To finance World War I, Washington even inserted gold clauses into Liberty Loans.

The powerful deflation of the early 1930s gave Roosevelt the excuse to end the gold standard. Dirt-low commodity prices, starving farmers, bank seizures of homes, 20% unemployment: All these miseries shouted, "looser money now!" The agricultural community, including eccentric Agriculture Secretary Henry Wallace, viewed the end of the gold standard as the ultimate revenge of the farmers punishing Wall Street for its 1920s prosperity.

One night in April, 1933, FDR surprised a bunch of advisers, saying "Congratulate me." He'd taken the country off the gold standard, and now planned to personally manage the dollar's exchange rate and price levels. Hearing the news, colleagues "began to scold Mr. Roosevelt as though he were a perverse and particularly backward schoolboy," recalled Ray Moley. Secretary of State Cordell Hull, the great free trader, "looked as though he had been stabbed in the back. FDR took out a ten-dollar bill, examined it and said 'Ha! . . . How do I know it's any good? Only the fact that I think it is makes it so.'"

Congress then drafted a joint resolution declaring gold clauses – protection against any damage Roosevelt might do – to be "against public policy." Roosevelt couldn't wait to see the resolution become law. Henry Wallace wrote that Roosevelt "looked up at the clock and put down 4:40 p.m., June 5, 1933 and signed his name."

Randall Kroszner, a governor at the Federal Reserve Board, has studied this period and has noted that the price went up on most stocks and bonds, even gold-clause bonds, when the Supreme Court eventually validated FDR's action. Mr. Kroszner and others argue that the abrogation of the gold clause had some virtue because it reduced the cost and inconvenience of debt renegotiation in a period of credit crisis.

But you can also argue that those price movements were more an expression of relief that a futile battle was over rather than a vote of approval. In my own review of the period I found evidence that snatching away from investors the perfect inflation hedge hurt the economy.

The market rally in the spring of 1933 slowed as investors watched FDR fiddle with the dollar and commodities over the course of the fall. In 1934, FDR thought better of it all and fixed the dollar to gold again, albeit now at $35 dollars an ounce. But the abrogation of the gold clause suggested that Washington had no regard for property rights. The general uncertainty generated by government economic policies did not abate. Capital went on strike. The Great Depression endured to the end of the decade. The positive transparency that the Securities and Exchange Commission or the creation of deposit insurance brought to markets was offset by losses like that of the gold clause.

And from then on, the federal government enjoyed wider license to inflate. Without the gold-clause option, citizens tried out other hedges – today a line about the CPI may stand where the old gold line once stood. In the 1970s, Sen. Jesse Helms pushed for repeal of the old abrogation, and eventually, with the support of Treasury Secretary William Simon, he won. But the average investor never used the clause to the same extent.

Today, as in the last days of the gold clause, officials like Mr. Kroszner of the Fed's Board of Governors are weighing a difficult choice between efficient crisis management and property rights. People don't talk more about the damage of monetary uncertainty because that damage is so spread out – harder to discern than, say, a single giant event like the implosion of Bear Stearns. But the old gold clause footnote explains why we may see yet more angst over the Consumer Price Index, the TIPS bond, or even LIBOR, the London Interbank rate. We have lost our bearings and our confidence in money generally.

After a majority of the Supreme Court upheld the constitutionality of the gold clause abrogation, Justice James McReynolds read the dissent. Today McReynolds is generally regarded as an irrelevant reactionary, a footnote himself. But his rueful words ring true for those trying to reckon the dollar's future. It was, he said, "impossible to estimate the result of what has been done."

Miss Shlaes is a senior fellow in economic history at the Council on Foreign Relations and author of "The Forgotten Man: A New History of the Great Depression," out in paperback this week (Harper Perennial).

In the early 1980s, Ronald Reagan embraced the ideas of a small group of economists dubbed "supply-siders." They argued that lower taxes and slimmer government would stimulate growth, enterprise, harder work and higher levels of saving and investment. These views were widely ridiculed at the time, dismissed as "voodoo economics."

Barbara Kelley Reagan did succeed in lowering some taxes. But a Democrat-controlled Congress weakened their impact by raising government spending sharply, resulting in large budget deficits.

A quarter of a century later, many more countries have cut taxes and reined in heavy-handed government intervention. How far have they gone down this path, and with what success?

My study, "Big, Not Better?" (Centre for Policy Studies, 2008), looks at the performance of 20 countries over the past two decades. The first 10 have slimmer governments with revenue and expenditure levels below 40% of GDP. This group includes Australia, Canada, Estonia, Hong Kong, Ireland, South Korea, Latvia, Singapore, the Slovak Republic and the U.S.

I compared their records to the 10 higher-taxed, bigger-government economies: Austria, Belgium, Denmark, France, Germany, Italy, the Netherlands, Portugal, Sweden and the United Kingdom. Both groups cover a representative range of large, medium and small economies measured by their gross national incomes. The average incomes per capita of the two groups are similar ($27,046 and $30,426 respectively in 2005).

Most governments have reduced their top tax rates and spending-to-GDP ratios over the last decade or so, according to data published by the OECD, IMF and World Bank. But slimmer governments have done so at a faster pace, and to significantly lower levels. Their highest tax rate on personal income fell to a group average of 30% in 2006 from 36% in 1996. Top corporate rates were lowered to an average of 22% from 30%. Their average ratio of total government outlays to GDP fell to 31.6% in 2007, from an average peak level during the previous two decades of 40.4%

Investment growth jumped to an average annual rate of 5.9% in 2000-2005, from 3.8% over the previous decade. Exports have risen by 6.3% annually since 2000. The net result was a surge in economic growth. The IMF reports that GDP soared in the slimmer-government group at a 5.4% average annual rate from 1999-2008 (including its forecast for the current year), up from a 4.6% rate over the previous decade.

Over that same period, the bigger-government group was more timid in its tax reductions. Their highest individual rates declined to an average of 45% from 49%, and corporate rates to 29% from 35%. Furthermore, their average spending-to-GDP ratio only fell to 48.3% from a peak of 55.2%.

The bigger-government group therefore failed to gain any competitive advantages in global markets by generating or attracting larger investment funds. Their investment growth slowed to an average annual rate of 0.8% in 2000-2005, from 4.1% in 1990-2000. Their export growth rate almost halved to 3.1% annually in 2000-2005, down from 6.1% in 1990-2000. The bottom line is a drop in their average annual GDP growth rate to 2.1% in 1999-2008, from 2.3% over the previous decade.

Nor did they balance their books. They ran budgetary deficits averaging 1.1% of GDP in 2006, whereas slimmer governments generated an average surplus of 0.3% of GDP. Their net government debt averaged 39.2% of GDP in 2006, more than four times higher than the latter's. Interest payments on their debt took 2.3% of their GDP, compared with an average of just 0.5% in the slimmer-government group.

Slimmer-government countries also delivered more rapid social progress in some areas. They have, on average, higher annual employment growth rates (1.7% compared to 0.9% from 1995-2005). Their youth unemployment rates have been lower for both males and females since 2000. The discretionary income of households rose faster in the first group. This allowed their real consumption to increase by 4.1% annually from 2000-2005, up from 2.8% in 1990-2000. In the bigger-government group, the growth of household consumption has slowed to a 1.3% average annual rate, from 2.1% during the 1990-2000 period.

Faster economic growth in the first group also generated a more rapid increase in government revenue, despite (or rather, because of, supply-siders suggest) lower overall tax burdens.

Slimmer-government countries seem to have made better use of their smaller health resources. Total spending on health programs reached 9.5% of GDP in the bigger government group in 2004, 1.6 percentage points above the average in the slimmer-government group. Yet slimmer-government countries have raised their average life expectancy at birth at a faster pacer since 1990, reaching an average level of 78 years in 2005, just one year below the average for bigger spenders. Average life expectancy is now 80 years in Singapore, although government and private health programs combined cost only 3.7% of its GDP.

Finally, spending by bigger governments on social benefits (such as unemployment and disability benefits, housing allowances and state pensions) was higher (20.3% of GDP in 2006) than that of slimmer governments (9.6%). But these transfers do not appear to have resulted in greater equality in the distribution of income. The Gini index measuring income distribution is similar for both groups.

Other forces clearly helped to narrow income disparities in slimmer-government economies. These forces include wage-setting practices, saving habits, the availability of employer-funded pension schemes, and income sharing among extended families.

Both groups reduced the share of defense spending in GDP over the past decade. The slimmer-government average fell 0.1 points to 2.2% in 2005, but this level was 0.5 percentage points above the bigger-government average. The average share of armed forces personnel in the total labor force in the bigger-government group fell to 1.1% from 1.5% in 1995, whereas it grew to 1.7% from 1.5% in the slimmer-government group.

Information on public order and safety expenditures is incomplete. But for the 11 countries for which data are available, slimmer governments seem to take their responsibilities more seriously. They spent an average of 1.8% of GDP on these functions in 2006, compared with 1.5% by bigger governments.

The early supply-siders were right. My findings firmly reject the widely held view that lower taxes inevitably result in cuts in public services, slower growth and widening income inequalities. Today's policy makers should take note of how tax cuts and the pruning of inefficient government programs can stimulate sluggish economies.

Mr. Marsden, a fellow of the Centre for Policy Studies in London, was previously an adviser at the World Bank and senior economist in the International Labour Organization.

Robert Mundell isn't in the habit of making fruitless policy recommendations, though some take a long time ripening. Nearly four decades passed between his early work on optimal currency areas and the birth of the euro in 1999 – the same year he received the Nobel Prize for economics.

Terry Shoffner So when Mr. Mundell says that rescinding the Bush tax cuts "would be devastating to the world economy," that oil prices are "not so far off track," that Asia needs its own multilateral currency, or that the ham sandwiches sitting before us could use some mustard, one is inclined to pay attention – and, except in the case of lunch, to think long term.

It's late May, and we are in surprisingly sunny Denmark for a Copenhagen Consensus summit. Mr. Mundell is one of eight economists debating cost-effective solutions to such problems as malnutrition and global warming. Europe is a natural enough place to meet the Ontario native, and not only because of his advocacy for the euro. When Mr. Mundell is not in New York City – where he's a professor at Columbia University and occasionally appears on David Letterman's late-night TV show (reading from Paris Hilton's book, listing the top 10 ways winning the Nobel has changed his life) – he's often in Tuscany at his 500-year-old castle, "Palazzo Mundell," restored in part with his Nobel winnings.

Back in America, there's an election going on. There's also been a spate of financial problems, not the least of which is a weak dollar. But Mr. Mundell says "the big issue economically . . . is what's going to happen to taxes."

Democratic nominee Barack Obama regularly professes disdain for the Bush tax cuts, suggesting that those growth-spurring measures may be scrapped. "If that happens," Mr. Mundell predicts, "the U.S. will go into a big recession, a nosedive."

One of the original "supply-side" economists, he has long preached the link between tax rates and economic growth. "It's a lethal thing to suddenly raise taxes," he explains. "This would be devastating to the world economy, to the United States, and it would be, I think, political suicide" in a general election.

Should taxes instead be cut again, I ask him, to stimulate the sluggish economy? Mr. Mundell replies that he favors a ceiling of 30% on marginal rates (the current top rate is 35%). He recounts how the past century experienced a titanic struggle over whether tax rates are too high or too low: from a 3% income tax in 1913; up to 60% during World War I; down to 25% before Congress and President Herbert Hoover raised taxes back to 60% in 1932 and "sealed the fate of our economy for a long, long time"; all the way up to 92.5% during World War II before falling in three steps, reaching 28% under President Ronald Reagan; and back to nearly 40% under Bill Clinton before George W. Bush lowered them to their current level.

In light of this fiscal roller coaster, Mr. Mundell says, "the most important thing that could be done with respect to tax rates now is to make the Bush tax cuts permanent. Eliminating that uncertainty would be more important than pushing for a further cut – in the income tax rates, anyway."

One tax that he would cut, to 25%, is the corporate tax rate. "It could be even lower," he says, "but I think it would be a big step to lower it to 25% . . . I made that proposal back in the 1970s."

A long-haired Mr. Mundell spent that decade not only arguing for the euro, but laying the intellectual groundwork for the Reagan tax-cut revolution. Mr. Mundell says those tax cuts remain "as important to the United States as the creation of the euro was to Europe – a fundamental change." Combined with Paul Volcker's tight-money policy at the Fed, which Mr. Mundell also championed, supply-side economics killed off stagflation.

Or at least it killed it off at the time. With prices again rising as growth slows, some economists are worried that stagflation could be making a comeback. Not Mr. Mundell – not yet.

He draws a comparison with the situation in 1979-1980. Start with the dollar price of oil, which he calls "one of the two most important prices in the world" (the other being the dollar-euro exchange rate, which we'll get to in a moment).

"If you look at the price level since 1980," he begins, "oil prices would naturally double by the year 2000. So from $34 a barrel in 1980 to $68 a barrel. And then . . . because the inflation rate's about 3.5%, it would double again by 2020. So the natural price . . . would be something like $136 in 2020.

"Now, we [already] got to $130-something, but . . . I really think the price is going to settle down, probably below $100, if not below $90. What I'm saying is we're not so far off track."

American motorists still shocked by $4-a-gallon gasoline might think we're rather more off track than Mr. Mundell suggests. Bolstering his case, he immediately moves on to another commodity often invoked to demonstrate inflation: gold.

"The price of gold in 1980 was $850 an ounce. And the price of gold today is about the same. It's astonishing," he says. "It's true, gold did go up" to more than $1,000 an ounce earlier this year, "but the public doesn't believe that there is inflation. If there was big inflation coming, then you'd see the price of gold going up to $1,500 an ounce very quickly, and that hasn't happened."

In any case, don't expect to hear Barack Obama or John McCain talk about the weak dollar's contributions to any problem. "As [journalist] Robert Novak once put it, it's like cleaning ladies who come in and say 'I don't do ironing.' [Politicians] say, 'I don't do exchange rates,'" Mr. Mundell chuckles. "They think they can only lose by talking about exchange rates, because they don't know enough about it, and it's hard to predict anyway, for anyone."

If Mr. Mundell had his way, there wouldn't be anything for politicians to say about exchange rates. They would be fixed – as they were under the Bretton Woods arrangement after World War II until 1971, when President Nixon took the U.S. off the postwar gold standard and effectively launched the era of floating exchange rates.

"It's a very poor and a dangerous system," Mr. Mundell says of the floating regime, "because it creates exaggerated swings in the exchange rate." Case in point is the dollar-euro rate. From a low of about 82 cents in 2000, Europe's common currency has risen fairly steadily and has been valued at more than $1.50 since late February, even breaking the $1.60 barrier once.

"What people have to realize is there's been a fundamental change in the way markets work in the past 20 years," Mr. Mundell says. "Now, exchange rates are driven not so much by trade but by capital accounts and capital movements, and the huge amount of liquidity that's sloshing around the world."

Central banks world-wide, he notes, are trying to reach an equilibrium between dollars and euros in their $6.5 trillion worth of foreign reserves. Roughly two-thirds of these reserves are kept in dollars now, so they have about $1 trillion left to move into euros.

"If you did a hundred billion dollars" annually, Mr. Mundell points out, "you'd need 10 years to build that up, and that amount of capital movement has a tremendous effect in keeping the euro overvalued. It's not good for Europe and . . . ultimately it would cause more inflation in the United States."

But this continuing shift doesn't mean that the dollar's status as the world's dominant currency is in danger, at least not in the short run. Countries like Iran may be pushing for the pricing of oil in another currency, "but it wouldn't happen unless Saudi Arabia and the Gulf states moved in that direction, and I don't see any way in which they would do this," Mr. Mundell says. "It would be very damaging to the relations between the United States and the Gulf countries. There's an implicit defense alliance between those, and that's what overrides as a top priority."

Nor is there a macroeconomic argument for demoting the dollar. "Remember, the growth prospects for the United States are probably stronger than that of Europe, because you've got continued and substantial population growth in the United States, and zero population growth in Europe," Mr. Mundell says. "Quite apart from the fact that the U.S. economy is innovating more rapidly, and the population is younger and not getting old as rapidly, so they pick up new technology faster. So I look upon the United States still as the main sparkplug of economic growth in the world."

As for the euro's overvalued status, he forecasts deflation in Europe, along with a slowdown and an end to its housing boom. The answer, he suggests, is for the Federal Reserve and the European Central Bank to cooperate in putting a floor and a ceiling on both the euro and the dollar. "You have to grope" to the appropriate range, he maintains, but a good starting point would be to keep the euro between 90 cents and $1.30.

Even better, in his mind – and now we're really talking long term – would be to have a global currency. This could take the form of a new money or a dominant existing one to which all others are fixed – probably the dollar. "As Paul Volcker says," Mr. Mundell relates, "the global economy needs a global currency."

To get there, he proposes holding a new, Bretton Woods-type meeting in 2010 at the Shanghai World's Fair. Mr. Mundell, who has been spending "a lot of time" in China advising the government, says reviving an international system of fixed exchange rates would be a tremendous help to Beijing as it tries to fend off demands from U.S. and European politicians that it appreciate or float its currency.

Here, he recalls Washington's similar "bashing" of the Japanese yen in the 1980s, and its ultimately disastrous effects: "Japan got stuck with an overvalued currency for a decade, and suffered from a perpetual deflation in its housing market from 1990 until just a couple of years ago. And China doesn't want to have the same problem."

Another part of his solution is for Asian countries to form their own currency bloc. If they did so, he says, "it'd be comparable in size to the European and the American bloc. And then it would not be so much the question of . . . the U.S. and Europe bashing China" or other rising economies.

These three currency blocs, he predicts, would be large enough to weather wide swings in their exchange rates. But the swings would still do economic damage, so "the best thing you could do is to stabilize them, and that's where the global currency comes in."

Could it happen? Mr. Mundell allows that three decades may pass, but predicts that like the euro and the Reagan revolution before it, the global currency's time, too, will come. Any skeptics might want to review the last few decades before betting against him.

Mr. Wingfield is an editorial-page writer for The Wall Street Journal Europe.

When the American economy enters a downturn, you often hear the experts debating whether it is likely to be V-shaped (short and sharp) or U-shaped (longer but milder). Today, the American economy may be entering a downturn that is best described as L-shaped. It is in a very low place indeed, and likely to remain there for some time to come.

Virtually all the indicators look grim. Inflation is running at an annual rate of nearly 6 percent, its highest level in 17 years. Unemployment stands at 6 percent; there has been no net job growth in the private sector for almost a year. Housing prices have fallen faster than at any time in memory—in Florida and California, by 30 percent or more. Banks are reporting record losses, only months after their executives walked off with record bonuses as their reward. President Bush inherited a $128 billion budget surplus from Bill Clinton; this year the federal government announced the second-largest budget deficit ever reported. During the eight years of the Bush administration, the national debt has increased by more than 65 percent, to nearly $10 trillion (to which the debts of Freddie Mac and Fannie Mae should now be added, according to the Congressional Budget Office). Meanwhile, we are saddled with the cost of two wars. The price tag for the one in Iraq alone will, by my estimate, ultimately exceed $3 trillion.

This tangled knot of problems will be difficult to unravel. Standard prescriptions call for raising interest rates when confronted with inflation, just as standard prescriptions call for lowering interest rates when confronted with an economic downturn. How do you do both at the same time? Not in the way that some politicians have proposed. With gasoline prices at all-time highs, John McCain has called for a rollback of gas taxes. But that would lead to more gas consumption, raise the price of gas further, increase our dependence on foreign oil, and expand our already massive trade deficit. The expanding deficit would in turn force the U.S. to continue borrowing gargantuan sums from abroad, making us even more indebted. At the same time, the higher imports of oil and petroleum-based products would lead to a weaker dollar, fueling inflationary pressures.

Millions of Americans are losing their homes. (Already, some 3.6 million have done so since the subprime-mortgage crisis began.) This social catastrophe has severe economic effects. The banks and other financial institutions that own these mortgages face stunning reverses; a few, such as Bear Stearns, have already gone belly-up. To prevent America’s $5.2 trillion home financiers, Fannie Mae and Freddie Mac, from following suit, Congress authorized a blank check to cover their losses, but even that generosity failed to do the trick. Now the administration has taken over the two entities completely, a stunning feat for a supposedly market-oriented regime. These bailouts contribute to growing deficits in the short run, and to perverse incentives in the long run. Market economies work only when there is a system of accountability, but C.E.O.’s, investors, and creditors are walking away with billions, while American taxpayers are being asked to pick up the tab. (Freddie Mac’s chairman, Richard Syron, earned $14.5 million in 2007. Fannie Mae’s C.E.O., Daniel Mudd, earned $14.2 million that same year.) We’re looking at a new form of public-private partnership, one in which the public shoulders all the risk, and the private sector gets all the profit. While the Bush administration preaches responsibility, the words are addressed only to the less well-off. The administration talks about the impact of “moral hazard” on the poor “speculator” who borrowed money and bought a house beyond his ability to pay. But moral hazard somehow isn’t an issue when it comes to the high-stakes speculators in corporate boardrooms.

Ideology proclaimed that markets were always good and government always bad. While George W. Bush has done as much as he can to ensure that government lives up to that reputation—it is the one area where he has overperformed—the fact is that key problems facing our society cannot be addressed without an effective government, whether it’s maintaining national security or protecting the environment. Our economy rests on public investments in technology, such as the Internet. While Bush’s ideology led him to underestimate the importance of government, it also led him to underestimate the limitations of markets. We learned from the Depression that markets are not self-adjusting—at least, not in a time frame that matters to living people. Today everyone—even the president—accepts the need for macro-economic policy, for government to try to maintain the economy at near-full employment. But in a sleight of hand, free-market economists promoted the idea that, once the economy was restored to full employment, markets would always allocate resources efficiently. The best regulation, in their view, was no regulation at all, and if that didn’t sell, then “self-regulation” was almost as good.

The underlying idea was, on the face of it, absurd: that market failures come only in macro doses, in the form of the recessions and depressions that have periodically plagued capitalist economies for the past several hundred years. Isn’t it more reasonable to assume that these failures are just the tip of the iceberg? That beneath the surface lie a myriad of smaller but harder-to-assess inefficiencies? Let me venture an analogy from biology: A patient arrives at a hospital in serious condition. Now, it may be that the patient has simply fallen victim to one of those debilitating ailments that go around from time to time and can be cured by a massive dose of antibiotics. In this case we have a macro problem with a macro solution. But it could instead be that the patient is suffering from a decade of serious abuse—smoking, drinking, overeating, lack of exercise, a fondness for crystal meth—and that it has not only taken a catastrophic toll but also left him open to opportunistic infections of every kind. In other words, a buildup of micro problems has led to a macro problem, and no cure is possible without addressing the underlying issues. The American economy today is a patient of the second kind.

We are in the midst of micro-economic failure on a grand scale. Financial markets receive generous compensation—in the form of more than 30 percent of all corporate profits—presumably for performing two critical tasks: allocating savings and managing risk. But the financial markets have failed laughably at both. Hundreds of billions of dollars were allocated to home loans beyond Americans’ ability to pay. And rather than managing risk, the financial markets created more risk. The failure of our financial system to do what it is supposed to do matches in destructive grandeur the macro-economic failures of the Great Depression.

Economic theory—and historical experience—long ago proved the need for regulation of financial markets. But ever since the Reagan presidency, deregulation has been the prevailing religion. Never mind that the few times “free banking” has been tried—most recently in Pinochet’s Chile, under the influence of the doctrinaire free-market theorist Milton Friedman—the experiment has ended in disaster. Chile is still paying back the debts from its misadventure. With massive problems in 1987 (remember Black Friday, when stock markets plunged almost 25 percent), 1989 (the savings-and-loan debacle), 1997 (the East Asia financial crisis), 1998 (the bailout of Long Term Capital Management), and 2001–02 (the collapses of Enron and WorldCom), one might think there would be more skepticism about the wisdom of leaving markets to themselves.

The new populist rhetoric of the right—persuading taxpayers that ordinary people always know how to spend money better than the government does, and promising a new world without budget constraints, where every tax cut generates more revenue—hasn’t helped matters. Special interests took advantage of this seductive mixture of populism and free-market ideology. They also bent the rules to suit themselves. Corporations and the wealthy argued that lowering their tax rates would lead to more savings; they got the tax breaks, but America’s household savings rate not only didn’t rise, it dropped to levels not seen in 75 years. The Bush administration extolled the power of the free market, but it was more than willing to provide generous subsidies to farmers and erect tariffs to protect steelmakers. Lately, as we have seen, it seems willing to write blank checks to bail out its friends on Wall Street. In each of these cases there are clear winners. And in each there are clear losers—including the country as a whole.What Is to Be Done?

As America attempts to work its way out of the present crisis, the danger is that we will listen to the same people on Wall Street and in the economic establishment who got us into it. For them, our current predicament is another opportunity: if they can shape the government response appropriately, they stand to gain, or at least stand to lose less, and they may be willing to sacrifice the well-being of the economy for their own benefit—just as they did in the past.

There are a number of economic tools at the country’s disposal. As noted, they can yield contradictory results. The sad truth is that we have reached the limits of monetary policy. Lowering interest rates will not stimulate the economy much—banks are not going to be willing to lend to strapped consumers, and consumers are not going to be willing to borrow as they see housing prices continue to fall. And raising interest rates, to combat inflation, won’t have the desired impact either, because the prices that are the main sources of our inflation—for food and energy—are determined in international markets; the chief consequence will be distress for ordinary people. The quandaries that we face mean that careful balancing is required. There is no quick and easy fix. But if we take decisive action today, we can shorten the length of the downturn and reduce its magnitude. If at the same time we think about what would be good for the economy in the long run, we can build a durable foundation for economic health.

To go back to that patient in the emergency room: we need to address the underlying causes. Most of the treatment options entail painful choices, but there are a few easy ones. On energy: conservation and research into new technologies will make us less dependent on foreign oil, reduce our trade imbalance, and help the environment. Expanding drilling into environmentally fragile areas, as some propose, would have a negligible effect on the price we pay for oil. Moreover, a policy of “drain America first” will make us more dependent on foreigners in the future. It is shortsighted in every dimension.

Our ethanol policy is also bad for the taxpayer, bad for the environment, bad for the world and our relations with other countries, and bad in terms of inflation. It is good only for the ethanol producers and American corn farmers. It should be scrapped. We currently subsidize corn-based ethanol by almost $1 a gallon, while imposing a 54-cent-a-gallon tariff on Brazilian sugar-based ethanol. It would be hard to invent a worse policy. The ethanol industry tries to sell itself as an infant, needing help to get on its feet, but it has been an infant for more than two decades, refusing to grow up. Our misguided biofuel policy is taking land used for food production and diverting it to energy production for cars; it is the single most important factor contributing to higher grain prices.

Our tax policies need to be changed. There is something deeply peculiar about having rich individuals who make their money speculating on real estate or stocks paying lower taxes than middle-class Americans, whose income is derived from wages and salaries; something peculiar and indeed offensive about having those whose income is derived from inherited stocks paying lower taxes than those who put in a 50-hour workweek. Skewing the tax rates in the other direction would provide better incentives where they count and would more effectively stimulate the economy, with more revenues and lower deficits.

We can have a financial system that is more stable—and even more dynamic—with stronger regulation. Self-regulation is an oxymoron. Financial markets produced loans and other products that were so complex and insidious that even their creators did not fully understand them; these products were so irresponsible that analysts called them “toxic.” Yet financial markets failed to create products that would enable ordinary households to face the risks they confront and stay in their homes. We need a financial-products safety commission and a financial-systems stability commission. And they can’t be run by Wall Street. The Federal Reserve Board shares too much of the mind-set of those it is supposed to regulate. It could and should have known that something was wrong. It had instruments at its disposal to let the air out of the bubble—or at least ensure that the bubble didn’t over-expand. But it chose to do nothing.

Throwing the poor out of their homes because they can’t pay their mortgages is not only tragic—it is pointless. All that happens is that the property deteriorates and the evicted people move somewhere else. The most coldhearted banker ought to understand the basic economics: banks lose money when they foreclose—the vacant homes typically sell for far less than they would if they were lived in and cared for. If banks won’t renegotiate, we should have an expedited special bankruptcy procedure, akin to what we do for corporations in Chapter 11, allowing people to keep their homes and re-structure their finances.

If this sounds too much like coddling the irresponsible, remember that there are two sides to every mortgage—the lender and the borrower. Both enter freely into the deal. One might say that both are, accordingly, equally responsible. But one side—the lender—is supposed to be financially sophisticated. In contrast, the borrowers in the subprime market consist mainly of people who are financially unsophisticated. For many, their home is their only asset, and when they lose it, they lose their life savings. Remember, too, that we already give big homeowner subsidies, through the tax system, to affluent families. With tax deductions, the government is paying in some states almost half of all mortgage interest and real-estate taxes. But many lower-income people, whose deductions are meaningless because their tax bill is too small, get no help. It makes much more sense to convert these tax deductions into cashable tax credits, so that the fraction of housing costs borne by the government for the poor and the rich is the same.

About these matters there should be no debate—but there will be. Already, those on Wall Street are arguing that we have to be careful not to “over-react.” Over-reaction, we are told, might stifle “innovation.” Well, some innovations ought to be stifled. Those toxic mortgages were certainly innovative. Other innovations were simply devices to circumvent regulations—regulations intended to prevent the kinds of problems from which our economy now suffers. Some of the innovations were designed to tart up the bottom line, moving liabilities off the balance sheet—charades designed to blur the information available to investors and regulators. They succeeded: the full extent of the exposure was not clear, and still isn’t. But there is a reason we need reliable accounting. Without good information it is hard to make good economic decisions. In short, some innovations come with very high price tags. Some can actually cause instability.

The free-market fundamentalists—who believe in the miracles of markets—have not been averse to accepting government bailouts. Indeed, they have demanded them, warning that unless they get what they want the whole system may crash. What politician wants to be blamed for the next Great Depression, simply because he stood on principle? I have been critical of weak anti-trust policies that allowed certain institutions to become so dominant that they are “too big to fail.” The harsh reality is that, given how far we’ve come, we will see more bailouts in the days ahead. Now that Fannie Mae and Freddie Mac are in federal receivership, we must insist: not a dime of taxpayer money should be put at risk while shareholders and creditors, who failed to oversee management, are permitted to walk away with anything they please. To do otherwise would invite a recurrence. Moreover, while these institutions may be too big to fail, they’re not too big to be reorganized. And we need to remember why we’re bailing them out: in order to maintain a flow of money into mortgage markets. It’s outrageous that these institutions are responding to their near-monopoly position by raising fees and increasing the costs of mortgages, which will only worsen the housing crisis. They, and the financial markets, have shown little interest in measures that could help millions of existing and potential homeowners out of the bind they’re in.

The hardest puzzles will be in monetary policy (balancing the risks of inflation and the risk of a deeper downturn) and fiscal policy (balancing the risk of a deeper downturn and the risk of an exploding deficit). The standard analysis coming from financial markets these days is that inflation is the greatest threat, and therefore we need to raise interest rates and cut deficits, which will restore confidence and thereby restore the economy. This is the same bad economics that didn’t work in East Asia in 1997 and didn’t work in Russia and Brazil in 1998. Indeed, it is the same recipe prescribed by Herbert Hoover in 1929.

It is a recipe, moreover, that would be particularly hard on working people and the poor. Higher interest rates dampen inflation by cutting back so sharply on aggregate demand that the unemployment rate grows and wages fall. Eventually, prices fall, too. As noted, the cause of our inflation today is largely imported—it comes from global food and energy prices, which are hard to control. To curb inflation therefore means that the price of everything else needs to fall drastically to compensate, which means that unemployment would also have to rise drastically.

In addition, this is not the time to turn to the old-time fiscal religion. Confidence in the economy won’t be restored as long as growth is low, and growth will be low if investment is anemic, consumption weak, and public spending on the wane. Under these circumstances, to mindlessly cut taxes or reduce government expenditures would be folly.

But there are ways of thoughtfully shaping policy that can walk a fine line and help us get out of our current predicament. Spending money on needed investments—infrastructure, education, technology—will yield double dividends. It will increase incomes today while laying the foundations for future employment and economic growth. Investments in energy efficiency will pay triple dividends—yielding environmental benefits in addition to the short- and long-run economic benefits.

The federal government needs to give a hand to states and localities—their tax revenues are plummeting, and without help they will face costly cutbacks in investment and in basic human services. The poor will suffer today, and growth will suffer tomorrow. The big advantage of a program to make up for the shortfall in the revenues of states and localities is that it would provide money in the amounts needed: if the economy recovers quickly, the shortfall will be small; if the downturn is long, as I fear will be the case, the shortfall will be large.

These measures are the opposite of what the administration—along with the Republican presidential nominee, John McCain—has been urging. It has always believed that tax cuts, especially for the rich, are the solution to the economy’s ills. In fact, the tax cuts in 2001 and 2003 set the stage for the current crisis. They did virtually nothing to stimulate the economy, and they left the burden of keeping the economy on life support to monetary policy alone. America’s problem today is not that households consume too little; on the contrary, with a savings rate barely above zero, it is clear we consume too much. But the administration hopes to encourage our spendthrift ways.

What has happened to the American economy was avoidable. It was not just that those who were entrusted to maintain the economy’s safety and soundness failed to do their job. There were also many who benefited handsomely by ensuring that what needed to be done did not get done. Now we face a choice: whether to let our response to the nation’s woes be shaped by those who got us here, or to seize the opportunity for fundamental reforms, striking a new balance between the market and government.

Joseph E. Stiglitz, a Nobel Prize–winning economist, is a professor at Columbia University.

As a Noble winner, Stiglitz is certainly a big name, but I find this piece singularly unimpressive.

For example, lets look at his list of woe:

"Virtually all the indicators look grim. Inflation is running at an annual rate of nearly 6 percent, its highest level in 17 years. Unemployment stands at 6 percent; there has been no net job growth in the private sector for almost a year. Housing prices have fallen faster than at any time in memory—in Florida and California, by 30 percent or more. Banks are reporting record losses, only months after their executives walked off with record bonuses as their reward. President Bush inherited a $128 billion budget surplus from Bill Clinton; this year the federal government announced the second-largest budget deficit ever reported. During the eight years of the Bush administration, the national debt has increased by more than 65 percent, to nearly $10 trillion (to which the debts of Freddie Mac and Fannie Mae should now be added, according to the Congressional Budget Office). Meanwhile, we are saddled with the cost of two wars. The price tag for the one in Iraq alone will, by my estimate, ultimately exceed $3 trillion."

a) inflation is a function of too much money being printed. Gold has gone from $250 to over $900 during the Bush years and interest rates are negative. The govt, via the Fed, prints money and as such this is 100% a government caused problem. b) the 6% number he quotes for inflation, is that of one month at the peak of peak oil prices, which have declined dramatically since then. I don't know the time lag for new data, but it will be intereting to see. I comment that making the point as he does based upon one month, a month which I am sure a bright fellow likes him to know to be a typical, is the sort of type of persuasion that I would expect from a chattering class piece, not a Nobel laureate.c) Again, the government deficit is a function of , , , drum roll please , , , the government!!! Duh!!! The deficit has increased despite an increase in revenues (until this year at any rate!) because , , , shocking development here , , , government spending has increased dramatically.d) FM and FM, and their debt, are the creations of , , , the government!!!e) war is waged by , , , the government!!!

Yet somehow from this tale of woe he concludes the cause was the free market and the solution is , , , the government!!!

I find it remarkably unserious for a lengthy piece (lengthy enough to require two entries in our forum here) by a serious economist to not address that the government has pushed private behavior towards the reckless due to causing inflation, due to negative interest rates, due to a dramatically fallling currency, due to the force of law of the CRA (Community Reinvestment Act or something like that) which forced lenders to lend to mass numbers of unqualified people-- people who numbers now swell the data of foreclosures--and particulary due to the FMs and all that they have spawned. Add in the unintended consequences of the "mark to market" regulations too! For him not to address these points in a piece that blames the free market and proposes MORE GOVERNMENT is simply extraordinary.

I am unable to comprehend the derivatives thing enough to comment there, but until I do understand better, it seems to me that what transpired would not have transpired or would have transpired to a significantly lesser degree but for the underlying impetus of unsound money and negative interest rates.

I have really found them really useful in understanding the current situation. I listen to the podcasts daily and every day I learn something new. It is obviously NPR but they have a wide variety of guests with different view points including a visit by Ralph Reed. He was sitting around waiting to be interviewed by another station and they talked him into appearing on the show

Doctor DoomThe Worst Is Not Behind UsNouriel Roubini 11.13.08, 12:01 AM ETIt is useful, at this juncture, to stand back and survey the economic landscape--both as it is now, and as it has been in recent months. So here is a summary of many of the points that I have made for the last few months on the outlook for the U.S. and global economy, as well as for financial markets:

--The U.S. will experience its most severe recession since World War II, much worse and longer and deeper than even the 1974-1975 and 1980-1982 recessions. The recession will continue until at least the end of 2009 for a cumulative gross domestic product drop of over 4%; the unemployment rate will likely reach 9%. The U.S. consumer is shopped-out, saving less and debt-burdened: This will be the worst consumer recession in decades.

--The prospect of a short and shallow six- to eight-month V-shaped recession is out of the window; a U-shaped 18- to 24-month recession is now a certainty, and the probability of a worse, multi-year L-shaped recession (as in Japan in the 1990s) is still small but rising. Even if the economy were to exit a recession by the end of 2009, the recovery could be so weak because of the impairment of the financial system and the credit mechanism that it may feel like a recession even if the economy is technically out of the recession.

--Obama will inherit an economic and financial mess worse than anything the U.S. has faced in decades: the most severe recession in 50 years; the worst financial and banking crisis since the Great Depression; a ballooning fiscal deficit that may be as high as a trillion dollars in 2009 and 2010; a huge current account deficit; a financial system that is in a severe crisis and where deleveraging is still occurring at a very rapid pace, thus causing a worsening of the credit crunch; a household sector where millions of households are insolvent, into negative equity territory and on the verge of losing their homes; a serious risk of deflation as the slack in goods, labor and commodity markets becomes deeper; the risk that we will end in a deflationary liquidity trap as the Fed is fast approaching the zero-bound constraint for the Fed funds rate; the risk of a severe debt deflation as the real value of nominal liabilities will rise, given price deflation, while the value of financial assets is still plunging.

--The world economy will experience a severe recession: Output will sharply contract in the Eurozone, the U.K. and the rest of Europe, as well as in Canada, Japan and Australia/New Zealand. There is also a risk of a hard landing in emerging market economies. Expect global growth--at market prices--to be close to zero in Q3 and negative by Q4. Leaving aside the effects of the fiscal stimulus, China could face a hard landing growth rate of 6% in 2009. The global recession will continue through most of 2009.

--The advanced economies will face stag-deflation (stagnation/recession and deflation) rather than stagflation, as the slack in goods, labor and commodity markets will lead advanced economies' inflation rates to become below 1% by 2009.

--Expect a few advanced economies (certainly the U.S. and Japan and possibly others) to reach the zero-bound constraint for policy rates by early 2009. With deflation on the horizon, zero-bound on interest rates implies the risk of a liquidity trap where money and bonds become perfectly substitutable, where real interest rates become high and rising, thus further pushing down aggregate demand, and where money market fund returns cannot even cover their management costs.

Deflation also implies a debt deflation where the real value of nominal debts is rising, thus increasing the real burden of such debts. Monetary policy easing will become more aggressive in other advanced economies even if the European Central Bank cuts too little too late. But monetary policy easing will be scarcely effective, as it will be pushing on a string, given the glut of global aggregate supply relative to demand--and given a very severe credit crunch.

--For 2009, the consensus estimates for earnings are delusional: Current consensus estimates are that S&P 500 earnings per share (EPS) will be $90 in 2009, up 15% from 2008. Such estimates are outright silly. If EPS falls--as is most likely--to a level of $60, then with a price-to-earnings (P/E) ratio of 12, the S&P 500 index could fall to 720 (i.e. about 20% below current levels).

If the P/E falls to 10--as is possible in a severe recession--the S&P could be down to 600, or 35% below current levels.

And in a very severe recession, one cannot exclude that EPS could fall as low as $50 in 2009, dragging the S&P 500 index to as low as 500. So, even based on fundamentals and valuations, there are significant downside risks to U.S. equities (20% to 40%).

Similar arguments can be made for global equities: A severe global recession implies further downside risks to global equities in the order of 20% to 30%.Thus, the recent rally in U.S. and global equities was only a bear-market sucker's rally that is already fizzling out--buried under a mountain of worse-than-expected macro, earnings and financial news.

--Credit losses will be well above $1 trillion and closer to $2 trillion, as such losses will spread from subprime to near-prime and prime mortgages and home equity loans (and the related securitized products); to commercial real estate, to credit cards, auto loans and student loans; to leveraged loans and LBOs, to muni bonds, corporate bonds, industrial and commercial loans and credit default swaps. These credit losses will lead to a severe credit crunch, absent a rapid and aggressive recapitalization of financial institutions.

--Almost all of the $700 billion in the TARP program will be used to recapitalize U.S. financial institutions (banks, broker dealers, insurance companies, finance companies) as rising credit losses (close to $2 trillion) will imply that the initial $250 billion allocated to recap these institutions will not be enough. Sooner rather than later, a TARP-2 will become necessary, as the recapitalization needs of U.S. financial institutions will likely be well above $1 trillion.

--Current spreads on speculative-grade bonds may widen further as a tsunami of defaults will hit the corporate sector; investment-grade bond spreads have widened excessively relative to financial fundamentals, but further spread-widening is possible, driven by market dynamics, deleveraging and the fact that many AAA-rated firms (say, GE) are not really AAA, and should be downgraded by the rating agencies.

--Expect a U.S. fiscal deficit of almost $1 trillion in 2009 and 2010. The outlook for the U.S. current account deficit is mixed: The recession, a rise in private savings and a fall in investment, and a further fall in commodity prices will tend to shrink it, but a stronger dollar, global demand weakness and a larger U.S. fiscal deficit will tend to worsen it. On net, we will observe still-large U.S. twin fiscal and current account deficits--and less willingness and ability in the rest of the world to finance it unless the interest rate on such debt rises.

--In this economic and financial environment, it is wise to stay away from most risky assets for the next 12 months: There are downside risks to U.S. and global equities; credit spreads--especially for the speculative grade--may widen further; commodity prices will fall another 20% from current levels; gold will also fall as deflation sets in; the U.S. dollar may weaken further in the next six to 12 months as the factors behind the recent rally weather off, while medium-term bearish fundamentals for the dollar set in again; government bond yields in the U.S. and advanced economies may fall further as recession and deflation emerge but, over time, the surge in fiscal deficits in the U.S. and globally will reduce the supply of global savings and lead to higher long-term interest rates unless the fall in global real investment outpaces the fall in global savings.

Expect further downside risks to emerging-markets assets (in particular, equities and local and foreign currency debt), especially in economies with significant macro, policy and financial vulnerabilities. Cash and cash-like instruments (short-term dated government bonds and inflation-indexed bonds that do well both in inflation and deflation times) will dominate most risky assets.

So, serious risks and vulnerabilities remain, and the downside risks to financial markets (worse than expected macro news, earnings news and developments in systemically important parts of the global financial system) will, over the next few months, overshadow the positive news (G-7 policies to avoid a systemic meltdown, and other policies that--in due time--may reduce interbank spreads and credit spreads).

Beware, therefore, of those who tell you that we have reached a bottom for risky financial assets. The same optimists told you that we reached a bottom and the worst was behind us after the rescue of the creditors of Bear Stearns in March; after the announcement of the possible bailout of Fannie and Freddie in July; after the actual bailout of Fannie and Freddie in September; after the bailout of AIG in mid-September; after the TARP legislation was presented; and after the latest G-7 and E.U. action.

In each case, the optimists argued that the latest crisis and rescue policy response was the cathartic event that signaled the bottom of the crisis and the recovery of markets. They were wrong literally at least six times in a row as the crisis--as I have consistently predicted over the last year--became worse and worse. So enough of the excessive optimism that has been proved wrong at least six times in the last eight months alone.

A reality check is needed to assess risks--and to take appropriate action. And reality tells us that we barely avoided, only a week ago, a total systemic financial meltdown; that the policy actions are now finally more aggressive and systematic, and more appropriate; that it will take a long while for interbank and credit markets to mend; that further important policy actions are needed to avoid the meltdown and an even more severe recession; that central banks, instead of being the lenders of last resort, will be, for now, the lenders of first and only resort; that even if we avoid a meltdown, we will experience a severe U.S., advanced economy and, most likely, global recession, the worst in decades; that we are in the middle of a severe global financial and banking crisis, the worst since the Great Depression; and that the flow of macro, earnings and financial news will significantly surprise (as during the last few weeks) on the downside with significant further risks to financial markets.

I'll stop now.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.

This could be filed several places and ultimately begins to document what I suspect folks in the future will regard as a monopoly battle similar to the Standard Oil/passenger/freight train monopolies of a century + ago.

Google may not be evil, but it sure does have enemies. Illustration: Tom RoweWhen Google's lawyers entered the smooth marble hallways of the Department of Justice on the morning of October 17, they had reason to feel confident. Sure, they were about to face the antitrust division—an experience most companies dread—to defend a proposed deal with Yahoo. But they had to like their chances. In the previous seven years, only one of the mergers that had been brought here had been opposed. And Google wasn't even requesting a full merger. It just wanted the go-ahead to pursue a small deal that it was convinced would benefit consumers, the two companies, and the search-advertising market as a whole. Settling around a large oval table in the conference room, the attorneys from Google and Yahoo prepared to make their arguments. Google wanted to serve its ads for certain search terms on Yahoo's pages in exchange for a share of the revenue those ads generated. It already had similar arrangements with AOL, Ask.com, and countless other Web sites. And the deal wasn't exclusive or permanent.

Tom Barnett, assistant attorney general for antitrust, took his seat at the table and called the meeting to order. The Yahoo lawyers kicked things off by describing their negotiations with DOJ staff; they had already suggested limiting the length of the deal and capping the amount of money in play. Barnett seemed unimpressed. "Staff," he proclaimed, "is irrelevant." He made the decisions around there.

As five lawyers involved with the case recount it, the rest of the meeting did not go much better. For hours, Barnett picked apart the deal. Google, he argued, was not preserving competition by keeping Yahoo solvent; it was trying to increase control over its old rival, with a goal of dominating the online search-advertising market. If the proposal was so harmless, he went on, why had he been deluged with letters and phone calls from advertisers opposing it? Then, late in the day, Barnett brought up the two words Google lawyers least wanted to hear: Section Two—as in, Section Two of the Sherman Antitrust Act, which criminalizes monopolies. The Justice Department invoked Section Two to splinter Standard Oil in 1911, break up AT&T in 1982, and prosecute Microsoft in 1998. Now Barnett was signaling not just that the Google-Yahoo deal was dead but that the government saw Google as a potential monopolist. In fact, Barnett insisted, if the deal wasn't substantially changed or scuttled, he would sue within five days. It was a stunning blow. Google had expected a speedy approval. Now the company, whose brand is defined by its "Don't be evil" slogan, faced the prospect of being hauled into court on an antitrust charge. Google and Yahoo tried to salvage the negotiations, but on the morning of November 5, three hours before the DOJ was going to file its antitrust case, they abandoned the deal.

Google's capitulation marked a rare defeat for the search giant, which has been almost as successful among the regulators of Washington as among the coders of Silicon Valley. And it was cause for celebration in Redmond, where Microsoft spent six months on a massive effort, costing millions of dollars, to block the Yahoo deal. Microsoft played a role in persuading members of Congress to hold hearings. It initiated a campaign that filled DOJ mailboxes with letters from politicians and nonprofit groups objecting to the deal. It convinced the country's largest advertisers to join together to oppose the company in public. It's impossible to know exactly what impact all this had on the DOJ decision. But many observers believe that Barnett, who declined to be interviewed for this article, was influenced in part by Microsoft's arguments.

The bid to stop the Yahoo deal was just one front in an emerging multipronged war against Google. The company's growth, ambitions, and politics have made it a target of some of the country's most powerful businesses and interest groups. When Google pressed the Federal Communications Commission to reallocate "white space"—unused chunks of radio spectrum—for wireless broadband and other uses, it ran into a counter-lobbying effort that included everyone from the National Association of Broadcasters to Dolly Parton. Google's push for net neutrality, which would forbid ISPs from giving preferential treatment to certain data providers, has been met by fierce resistance from telecom and cable companies, whose allies describe it as "special-interest legislation dressed up to sound less self-serving." It purchased YouTube, whose users' laissez-faire approach to copyright infuriates Viacom and other content providers. Google wants to digitize entire libraries, a prospect that frightens publishers. It has terrified a legion of small businesses that feel at the mercy of its opaque but all-powerful search algorithm. It has annoyed Republicans by associating itself largely with Democrats.

The thwarting of the Yahoo deal was the most successful attack so far by the many forces aligned against Google—but it won't be the last. "There were a lot of sharks circling Google during the DOJ review," says Christopher Murray, senior counsel for Consumers Union. "Now there's a whiff of blood in the water. I expect a feeding frenzy in 2009."

The Enemies ListGoogle is under fire on 4 fronts.

What's at stake:How much do you trust Google? The search giant says there's no reason to fear its purchase of DoubleClick or its proposed revenue-sharing deal with Yahoo. But competitors and major advertisers think it's plotting world domination.

Who's upset: Association of National Advertisers, Microsoft, WPP Group

What's at stake:Every time a new chunk of radio spectrum becomes available, Google argues it should be opened to the public. Sounds great—except to telcos that have wanted it for themselves and broadcasters that worry new devices will mess with their transmissions.

Who's upset: AT&T, National Association of Broadcasters, Verizon

What's at stake:Google thinks all information is created equal and favors laws forbidding Internet service providers from determining how fast content from different providers will download. ISPs, not surprisingly, beg to differ.

Who's upset: AT&T, Comcast, Verizon

What's at stake:Google's insatiable hunger for data scares even some of its allies. Now its business rivals have launched a privacy crusade to drum up fears that Big Brother lives in Mountain View.

Who's upset: AT&T, Center for Digital Democracy, Microsoft

High-profile legal battles aren't fought only in the courtroom. Public perceptions matter. Momentum matters. Relationships matter. For John Kelly, Microsoft's head of strategic relations, this lesson didn't come easy. In the 1990s, the lawyer and former lobbyist watched as Microsoft defended itself against charges that its practice of bundling its software onto computers constituted anticompetitive behavior. The company settled the case in 2001. But by then it had already won a reputation as an unrepentant and thuggish monopolist, thanks in part to shrewd lobbying by competitors like Sun Microsystems and Netscape, uninspiring testimony by Bill Gates, and masterful media relations by David Boies, the government lawyer on the case.

"Ten years ago we said, 'This is all going to depend on being right in court,'" Kelly says. "'Don't worry about all the noise, rhetoric, and lobbying by our competitors.' While the facts and the law are still what matters in the end, the important lesson we took way from that experience was that you could not let your competitors define you in the court of public opinion."

A decade later, Microsoft's reputation was still getting in its way. In January 2008, Microsoft made an unsolicited bid to purchase Yahoo. The takeover would help Microsoft bulk up its search advertising business, an area where Google held a huge advantage. But Yahoo CEO Jerry Yang, who viewed Microsoft as an uncompromising leviathan, was determined to block the deal. In early May, Microsoft dropped its bid—a tough defeat made even more frustrating when Google CEO Eric Schmidt celebrated the failure in comments to the media. "We're obviously happy it's not going to happen," Schmidt said at a press conference. "Had the merger gone through, we would have had to have a meeting around it. We would have had to have a campaign against it."

It was a stark reversal for Schmidt, who had made few public statements against Microsoft since joining Google in 2001. Kelly took the saber-rattling as a warning that Google was preparing to join the fray, perhaps by proposing its own deal to keep Yahoo out of Microsoft's hands. (Sure enough, Google did just that on June 12.) For years, Microsoft had quietly seethed as Google waltzed into a position of immense power while charming regulators and politicians with an aura of gee-whiz innocence. Even when Google hired a small team of lobbyists and took the occasional swing at Redmond, the company's feel-good reputation remained intact. The idea that Google would end up inking a deal with Yahoo, increasing its domination of search advertising while successfully casting Microsoft—again!—as a power-mad Darth Vader, was more than Kelly could stand. "Frankly, we saw history repeating itself," he says. "We realized that we were going to have to speak up."

Kelly sprang into action, activating his company's vast Washington infrastructure.Microsoft's protracted antitrust battles had left it with an army of lawyers and lobbyists and deep institutional knowledge of which politicians to approach and how best to sway them. Soon, Microsoft's lobbyists were meeting with Herbert Kohl, chair of the Senate's Antitrust Subcommittee. By early July the subcommittee was holding hearings. In October, Kohl wrote to Barnett warning that "important competition issues are raised by this transaction."

But that was all familiar, the kind of campaign Microsoft had routinely run. Kelly wanted to take a different approach this time—not just opposing the deal but persuading other interested parties to speak out as well. The arguments of a known competitor may not sway the Justice Department, but customers' opinions hold special influence. If advertisers—Google's customers—voluntarily declared their opposition, the DOJ would listen closely.

Kelly turned to Michael Kassan, an advertising consultant who had been advising Microsoft off and on since 2002. Kassan—whose clients have included AT&T, Disney, and Viacom—recently had been named by Advertising Age as possessing the third-most-impressive Rolodex in the industry. Kelly asked Kassan to start talking to his contacts and drum up opposition to Google. Kassan assured him he knew just how to do it; there was plenty of fear and mistrust of Google among advertisers. "Google has badly misjudged how it is perceived," he reassured Kelly. "We have a clear and easy story to tell."

It went like this: Google had 70 percent of the search advertising business, and Yahoo had 20 percent. Now those two companies were proposing a business deal. That would give advertisers less leverage to negotiate ad rates, and they would end up paying more.

Kassan was eager to make his case. He flew to Cannes, France, where he pitched the board of the International Association of Advertisers. He traveled to conferences in New York, Washington, Los Angeles, and Florida. He talked to many of the 32 chief marketing officers on the board of the Association of National Advertisers, the trade group that represents the top 375 advertisers in the country. By late August, Kelly and Kassan were conducting as many as three conference calls a day with major national advertisers. Google, meanwhile, hadn't started any serious outreach effort to defend the deal to the advertising community.

The hardest part of the campaign wasn't convincing ANA's board members that the Google-Yahoo proposal was bad for them. The trick, Kassan says, was getting them to say so. Indeed, Kassan was rebuffed in June, when he first asked the head of the ANA to take a public stand. "They wanted me to do something right away," ANA president Bob Liodice says. "I told them I'd look at it. But at the time I had no ability to say whether the deal was bad or good, and the last thing I wanted to do was have the organization looking like a shill for Microsoft."

Kassan and Kelly kept at Liodice, seeding his inbox with position papers, briefing documents, and news stories. Their goal was straightforward: Convince him that the ANA's position on the deal not only mattered but was crucial to stopping it. Liodice went on a fact-finding mission, inviting Google and Yahoo to answer questions and then sending written queries to executives at all three companies. Ultimately, he concluded that Google would drive Yahoo out of business and gain a stranglehold on online advertising. "The more we dug in, the more we realized that we had to say something," Liodice says. "The tipping point for me was that I had all these advertisers on my board opposing the deal. Meanwhile, Google and Yahoo couldn't produce any significant advertisers who were supporting it." In September, the ANA formally voiced its opposition. It wasn't alone; individual advertisers piled on with additional letters to the Justice Department expressing their own disapproval. DOJ staffers were talking about the "telephone book of complaints" they had received.

Microsoft's arguments weren't just winning over advertisers. Back in July, the company penned one of a series of confidential memos titled "Google + Yahoo ≠ Competition" and sent it to its allies and the Justice Department. The memo claimed that the Google-Yahoo deal was illegal on its face, mentioning as precedent the 68-year-old case United States v. Socony-Vacuum Oil Co. Inc., which Microsoft also cited in congressional testimony that same month. When Yahoo lawyer Dan Wall heard the argument, he didn't see how a 1940s case against conspiring oil companies bore much relevance to a deal in which prices are set by electronic auctions. But then a Justice official brought up Socony during one of their regular phone calls. "I thought, 'Good grief, they're buying the Microsoft BS,'" Wall says. "I don't have any doubt that Microsoft put that in DOJ's mind."

Meanwhile, the fight against Google quickly spread beyond Redmond, as other companies and trade groups began to lend support. Some had no obvious interest in the deal; Microsoft hired lobbyists who knew how to drum up support among rural and Latino groups, and before long organizations as far-reaching as the American Corn Growers Association and the Dominican American Business Network had voiced their opposition.

Other companies joined in, including AT&T. Many observers believe that the telecom company hopes to compete directly with Google someday by going into the business of serving online ads to its users, and it was happy for the opportunity to beat up on its future rival. On September 24, 10 members of Congress sent a letter to the DOJ opposing the deal. All of them have received donations from AT&T over their careers (average total contribution since 1996: $29,000), and most counted the telecom giant as one of their largest contributors.

These campaigns converged at the October 17 Justice Department hearing, in which Barnett threatened to bring an antitrust case against Google. Publicly, Google remained upbeat after the arrangement fell apart. Lobbyists for the company maintained that even in failure they had kept Yahoo out of the hands of Microsoft for at least six months, perhaps permanently. And if Microsoft eventually tries to snap up Yahoo, Google can respond with the same kind of antitrust arguments that were deployed against it.

Kassan doesn't share Google's optimistic interpretation. "They have permanently invited the scrutiny of the Justice Department into every future deal they do," he says. "Nine months ago everyone aspired to be Google. Now they have monopolist written all over them."

Google barely had time to recover from the failed Yahoo deal before its staff learned of a 94-page document titled "Google Data Collection and Retention," that had been circulating around Washington. The treatise listed all the ways that Google hoards user information. Google Checkout remembers credit card numbers. Gmail reads private email. Blogger saves draft posts. As one annotation on the document helpfully notes, Google's privacy policy "gives Google the right to retain personal information over the wishes of a user." Overall, Google is painted as a Big Brother with an insatiable desire for private data.

The document, written by a consulting firm, was commissioned by AT&T, which says it was intended only for internal use. Protection from snooping, says AT&T public policy chief James Cicconi, is one of his firm's top priorities. "We sell our customers access to the Internet," he says, "and we want them to have a good experience." Privacy is a newfound concern for the company, which in 2005 was one of the telecoms that allowed the National Security Agency to listen in on millions of phone calls. AT&T was accused of "warrantless wiretapping" before successfully lobbying Congress to grant it immunity against suits by its customers. But now AT&T is trumpeting the cause of consumer privacy, unveiling an elaborate policy stating that it will not sell its customers' browsing histories to advertisers without explicit permission.

But AT&T's nascent crusade may also be in the service of a less noble agenda: keeping up its attack on Google. Over the past couple of months, several AT&T allies have spoken out against what they describe as Google's disdain for privacy. Scott Cleland, who serves as CEO of a telecom-funded consultancy, has turned his widely read blog into a Google attack machine, with posts titled "Why Google Is the Biggest Threat to Americans' Privacy" and "Google Protecting Its Privacy to Invade Your Privacy." In late November, a cochair of an advocacy group called the Future of Privacy Forum published an op-ed in the Bangkok Post titled "Google Is Watching You." The writer was a former lawyer for AT&T, which is the group's sole funder. AT&T is also launching volleys under its own name: When its senior vice president of public policy introduced the company's new set of policies in front of the Senate, she repeatedly named Google as a privacy threat—and mentioned no other company in the entire testimony.

Once again, AT&T has found an ally in Microsoft. LMG, a public-relations firm that Microsoft hired to help defeat the Yahoo deal, has emailed public-interest advocates accusing Google of privacy violations. Last spring, Microsoft supported bills in the New York and Connecticut legislatures to impose strict regulations on businesses that gather personal information online for marketing purposes. The bills would hurt Microsoft, too, given that it also wants to sell advertisements based on customer behavior. But the self-inflicted wound may be worth it for the damage it causes Google.

True to form, Google remains cheery and confident. The company's reputation still beats the stodgy, unfriendly images of Microsoft and AT&T. Google executives also know they may be able to win some supporters on this issue; advertisers, the same group whose complaints torpedoed the Yahoo deal, aren't put off by Google's attempts to collect user data—it only helps them create more targeted ads.

And for all its woes in Washington, Google is finally learning how to operate there. It has hired more lobbyists, and its policy experts are starting to attend the cocktail parties they have long ignored. Schmidt serves as chair of the New America Foundation (a think tank at which one of the authors of this article is a fellow). And Google can now boast a uniquely powerful ally: Barack Obama, who benefited from Google employees' extensive campaign contributions and from Schmidt's well-timed endorsement.

AT&T maintains that even Google's Democratic pals might turn against the company over privacy. "Civil libertarians have fought hard over decades to establish a right to privacy as fundamental to preserving all other liberties enshrined in our Constitution," Cicconi says. "It would be shameful if liberals now toss that achievement over the side because a liberal, pro-Obama, hip-cool-trendy company comes along that wants to run roughshod over those rights." Leslie Harris, president of the Center for Democracy and Technology, a nonprofit that has long fought Google on privacy grounds, says she considers AT&T's recent interest in her cause "a perfect storm in our favor." And Google isn't out of the antitrust woods yet, either. Sanford Litvack—a government lawyer who would have run the DOJ's suit against Google had it not withdrawn the Yahoo proposal—says that, in his opinion, Google's current position may already constitute a monopoly, even without Yahoo.

Traditionally, Google has fought off powerful rivals with masterful code. It took on the established search behemoths by creating more effective software. It bested Microsoft's and Yahoo's advertising efforts by inventing an entirely new ad platform. But the war today is being fought in Washington, in the press, and perhaps even in the Justice Department again. And these aren't battles you can win with engineers and algorithms.

Before he was sworn in as President, Barack Obama began to lay out his plans for reviving an American economy that, it would later be discovered, had declined 3.8 percent in the fourth quarter of 2008, its worst performance in 26 years. About the first part of his project, “stimulating” businesses to invest and consumers to consume through government spending and tax remittances, he was forthcoming and enthusiastic. About the second, stabilizing the financial system, he wished to reserve judgment.

He anointed the stimulus proposal with a convenient and vivid metaphor. “We’re going to have to jump start this economy with my economic recovery plan,” he said on January 3. According to the image, one can jolt a dormant economy into action just as one can hook up polarized cables to a car battery, clamp a defibrillator to the chest, or breathe into the ear of a reluctant lover. Suddenly, the object of our attention will be back in action, aroused.

Alas, the questions raised by a proposed stimulus—whether to apply it, what sort it should be, how much it should cost, and when it should begin and end—are far trickier to answer than problems involving dead batteries. And, remarkably enough, history and economic research offer no conclusive answers. The recession that began in 2008 could turn out to be the worst slowdown since the Great Depression of the 1930’s. For three-quarters of a century, economists have been studying it diligently. And even now they cannot come to a definitive conclusion about the cause of that depression, the reasons for its severity and duration, or what cured it. In an introduction to a book of essays on the Great Depression he compiled in 2000, Ben S. Bernanke, then a Princeton professor and now chairman of the Federal Reserve Board, wrote, “Finding an explanation for the worldwide economic collapse of the 1930’s remains a fascinating intellectual challenge.”

Today, of course, the challenge is more than intellectual.

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When he wrote in 1936 that “practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist,” John Maynard Keynes surely did not have himself in mind. But, in times of trouble, Americans still cling to Keynes, or at least to the caricature of him as the economist who said you could spend your way out of a recession. His big idea was that, left to its own devices, an economy can fall into a slump and just stay there. Self-corrective mechanisms will not necessarily work on their own; they will need help.

Prosperity depends on investment, on businesses building new plants, buying new machines, and employing more workers. In a typical case, when an economy slows, businesses reduce their demand for credit. At the same time, worried consumers save their earnings in banks, and by doing so, add to the store of money available for lending. These two forces—as well as actions taken by the Federal Reserve Board—combine to push interest rates to levels so attractive that businesses start borrowing again, and the economy picks up. The Great Depression, however, was atypical. The economy slowed and interest rates fell, but businesses were so frightened about the future that they refused to invest; instead, they did the opposite, shutting plants and firing workers. As for consumers, while they may have wanted to save, they lacked the cash to put away. Because they were out of work, they depleted what savings they had.

Keynes argued that, when businesses and people cannot or will not invest, then the government must take on the role of filling the gap. The key is speed. The means, Keynes wrote in The General Theory of Employment, Interest and Money, really did not matter so much:

If the Treasury were to fill old bottles with bank notes, bury them at suitable depths in disused coal mines which are then filled to the surface with town rubbish and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again, . . . there need be no more unemployment and with the help of the repercussions, the real income of the community would probably become a good deal larger than it is.Of course, Keynes favored large public-works projects over the burying of bottles. Building roads in the right places, for example, would both put people to work and provide the basis for more commerce. At first, Keynes emphasized government spending as stimulus, but, when pressed in 1933, he advocated tax cuts as well—specifically in response to criticism that public-works projects do not put cash into the system quickly enough.

The dire situation for which Keynes prescribed a cure bears distressing similarities to our own. Interest rates set by the Fed stand effectively at zero percent, but banks are recalcitrant about lending and even businesses flush with cash are hesitant to invest. It appears that the current sickness occurred because the Fed, in an effort to keep the economy stimulated after the collapse of the tech-stock bubble and in the wake of September 11, cut interest rates far too much during 2001 (from 6.5 percent at the start of the year to 1.75 percent at the end) and waited too long to raise them, making credit so easy that businesses expanded beyond all reasonable bounds, and banks, flush with cash and trying to make higher returns, shoveled money at borrowers with poor credit; risk aversion disappeared, and loans, especially to home buyers, went bad. Booms do, after all, create their own busts.

In response, Congress last year voted funds for the Treasury to use to shore up financial institutions—the widely maligned Troubled Asset Relief Program, or TARP—and the Fed opened wide its lending window. Those actions forestalled mass failures, but banks, chastened by their past overindulgence and worried about depleting their capital, still do not want to lend. So while government action proved necessary (and remains necessary) to maintain public confidence in the banking system, it became clear those actions could not and would not mitigate the parlous effects of the recession that, we were told late in 2008, had begun at the end of 2007. So the question becomes: In a world in which monetary adjustments do not appear effective, can tax and spending policies pull us out of the slump?

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The track record is discouraging. Despite Franklin Roosevelt’s aggressive spending, unemployment reached 25 percent in 1933, fell only to 14 percent by 1937, and was back up to 19 percent in 1939.1 In the end, the New Deal did little or nothing to resuscitate the economy. Certainly, inept monetary policies helped prolong the Great Depression, as did tax increases, constant interventions in the conduct of business, and the erection of global trade barriers, beginning with the Smoot-Hawley Tariff in 1930, more than two years before Roosevelt took office. There was a stretch of twelve years from the stock-market crash to Pearl Harbor, and, during that time, fiscal stimulus simply did not jump-start the economy (or, in Keynes’s own metaphor, “awaken Sleeping Beauty”). Now, some do attempt to make the case that Roosevelt did not increase government spending enough during the early and mid-1930’s and that it took World War II and the unprecedented infusion of government dollars into the economy to provide the stimulus that finally pulled America from the swamp.

But even if that were true—and considering the fact that federal spending tripled during the Great Depression, rising from 3 percent of the country’s gross domestic product to nearly 10 percent in 1939,2 it does not seem the likeliest explanation—it still does not offer much in the way of guidance through our current thicket. Few economists today believe the United States could tolerate the kind of budget deficits that developed during World War II, which ran more than 50 percent of gross domestic product, or about $7 trillion annually in current terms. When the federal government ramped up its spending during the war, it had not yet grown into the entitlement cash machine it is now, spitting out trillions of dollars a year in retirement and health-care benefits.

Not only was the stimulative effect of Great Depression fiscal policy non-existent, but follow-on efforts during the ten subsequent recessions proved equally ineffective. As a result of that hard-won experience, the consensus until recently among economists was that attempts at stimulus through emergency fiscal policies—as opposed to monetary policies and the automatic effects of increases in unemployment assistance and decreases in tax payments—were useless at best. Typical was the statement of Martin Eichenbaum of Northwestern University in the American Economic Review in 1997: “There is now widespread agreement that countercyclical discretionary fiscal policy is neither desirable nor politically feasible.” Martin Feldstein, then president of the National Bureau of Economic Research, agreed. Fiscal stimulus, he said in 2002, “has not contributed to economic stability and may have actually been destabilizing.”

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A good place to turn to understand the failure of the jump-start is the work of Frederic Bastiat, a French politician of the early 19th century. “In the economic sphere,” he wrote,

an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.To prove his point, Bastiat described what happens when a vandal breaks a shopkeeper’s window. The seen effect is that repairing the glass creates economic value in the payment to the glazier, who then has money to buy a new suit or hire a part-time employee. What is unseen is that the shopkeeper has to pay the glazier with money that he would otherwise have used to buy a suit or add an employee. “The broken-window fallacy, under a hundred disguises, is the most persistent in the history of economics,” wrote the economic journalist Henry Hazlitt in 1946.

Like payments for broken windows, tax rebates and new roads (the seen) do not come free. The stimulus money that flows to taxpayers, government agencies, and businesses has to come from somewhere (the unseen). During a recession, it is usually borrowed, and the anticipation of taxpayers is that they will have to repay these loans, which means their taxes will rise in the future. This knowledge makes people anxious about spending the extra money, or even about investing it in the kind of ventures that help an economy grow.3

Lately, however, economists have become more sanguine about the power of fiscal stimulus, in large part because of the apparent success of the tax-rate reductions and rebates in 2001 and 2003 (although such a conclusion may ignore the monetary effects of the huge cut in interest rates). A summary of a conference held in May by the Federal Reserve Bank of San Francisco stated that “the consensus” against stimulus “has unraveled and perhaps even begun to emerge on the opposite viewpoint.” Last year, Jason Furman and Douglas Elmendorf of the Brookings Institution wrote, “Fiscal policy implemented promptly can provide a larger near-term impetus to economic policy than monetary policy can.” And, in a paper delivered to the American Economic Association in January, Feldstein himself switched sides and said he now favored tax cuts and government spending.

The views of these economists are undoubtedly heartfelt, but it must be recognized that one of the great attractions of Keynes’s theories is that he gives you permission to do what you wanted to do anyway. Feldstein, chairman of the Council of Economic Advisors under Ronald Reagan, proposes a stimulus policy that extends the Bush tax cuts currently scheduled to expire in 2011 and increases spending on defense and national intelligence. In their stimulus proposal, Furman, now deputy director of Obama’s National Economic Council, and Elmendorf, head of the Congressional Budget Office under the current Democratic majority, adamantly oppose extending the Bush cuts and instead want to extend unemployment and Food Stamp benefits and issue short-term tax credits, even to people who owe no taxes.

Also, in the new enthusiasm for stimulus, there is not a small degree of panic; monetary policy is not working, so fiscal policy must! To his credit, however, Feldstein writes toward the end of his January paper, “It is of course possible that the planned surge in government spending will fail. Two or three years from now we could be facing a level of unemployment that is higher than today and that shows no sign of coming down.”

The truth is that we have learned almost nothing about the use of fiscal stimulus since the Great Depression, and it is a fatal conceit to assume that we can hurriedly construct a fiscal policy that will produce the prescribed results today. Economists seem to admit this fact by advocating what they prefer anyway, for political or ideological reasons. I would feel better about stimulus if Elmendorf were clamoring for permanent tax cuts and Feldstein food stamps.

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On being presented the Nobel Prize in economics in 1974, Friedrich von Hayek devoted his Stockholm lecture to acknowledging the severe limitations of his profession. “It seems to me,” he said, “that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences—an attempt which in our field may lead to outright error.” Government simply cannot know enough to direct an economy successfully, and when the President claims that his fiscal stimulus plan will create (or save) at least three million jobs, he is taking a wild, and dangerous, leap. Said Hayek:

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.What is that environment? First, it provides a confidence that, in a crisis, bank deposits are safe and insurance policies will be paid in full. Such confidence can be provided only by the government of the United States in its legitimate and essential role as the lender of last resort. Second, the environment supports, rather than denigrates or browbeats, productive members of society. The U.S. will not emerge from a serious recession unless businesses and investors lead it out. Third, it recognizes that Americans have undergone a financial calamity and that we need time to adjust; we cannot, like a car battery, be shocked back to life, and we aren’t in the mood to have someone blow in our ear.

In fact, stimulus may be precisely the wrong metaphor. Rather than getting jazzed up, we need to be calmed down and to take the time to learn from the Great Depression, a time when government did too much, not too little. Amity Shlaes makes the argument in The Forgotten Man, her book about the Great Depression, that the constant experimenting and meddling of the New Deal froze investors and business operators in fear: “Businesses decided to wait Roosevelt out, hold on to their cash, and invest in future years.”

Despite the warnings of Keynes, the experience of the past half-century indicates that today’s low interest rates will start having a positive effect, though it still will take many months. Meanwhile, left alone, what Hayek called “spontaneous order” will find its way forward. Using a different metaphor, James Grant, in his history of credit, Money of the Mind, wrote, “The cycle of decay and renewal is as much a part of capitalism as it is of the forest floor.” But, in the 1930’s, “something in the normal regenerative process was missing. There was no decisive recovery from the business-cycle bottom. People had lost their speculative courage, and the more government legislated and taxed, the more that credit sulked.”

Stimulus—that is, fiscal intervention with the express purpose of speeding up the normal regenerative process that Grant describes—is unnecessary and almost certainly harmful, a policy based on hubris and anxiety, rather than on history and good sense. Under such circumstances, the proper way to analyze discrete proposals today for spending or taxing is on their own merits, not on their supposed ability to stimulate something else. There may, in fact, be a good reason for government to spend billions of dollars today on building highways, and it has nothing to do with stimulus. It is that long-term interest rates are at historic lows and that the right highways can boost the economy in the long term. There also may be a good reason, again far apart from stimulus, for revising the tax code and reforming Social Security and Medicare. It is that Americans now understand that the economic future is not so assured as they believed a couple of years ago, and it is time for decisions to be made—in a manner careful, sensible, and unstimulated.

ABOUT THE AUTHOR

James K. Glassman is the former Under Secretary of State for Public Diplomacy and Public Affairs. He is president of the World Growth Institute, which promotes global economic development.

Adam Smith gets the last laughBy P.J. O’RourkePublished: February 10 2009 19:22 | Last updated: February 10 2009 19:22The free market is dead. It was killed by the Bolshevik Revolution, fascist dirigisme, Keynesianism, the Great Depression, the second world war economic controls, the Labour party victory of 1945, Keynesianism again, the Arab oil embargo, Anthony Giddens’s “third way” and the current financial crisis. The free market has died at least 10 times in the past century. And whenever the market expires people want to know what Adam Smith would say. It is a moment of, “Hello, God, how’s my atheism going?”

Adam Smith would be laughing too hard to say anything. Smith spotted the precise cause of our economic calamity not just before it happened but 232 years before – probably a record for going short.

“A dwelling-house, as such, contributes nothing to the revenue of its inhabitant,” Smith said in The Wealth of Nations. “If it is lett [sic] to a tenant for rent, as the house itself can produce nothing, the tenant must always pay the rent out of some other revenue.” Therefore Smith concluded that, although a house can make money for its owner if it is rented, “the revenue of the whole body of the people can never be in the smallest degree increased by it”. [281]*

Smith was familiar with rampant speculation, or “overtrading” as he politely called it.

The Mississippi Scheme and the South Sea Bubble had both collapsed in 1720, three years before his birth. In 1772, while Smith was writing The Wealth of Nations, a bank run occurred in Scotland. Only three of Edinburgh’s 30 private banks survived. The reaction to the ensuing credit freeze from the Scottish overtraders sounds familiar, “The banks, they seem to have thought,” Smith said, “were in honour bound to supply the deficiency, and to provide them with all the capital which they wanted to trade with.” [308]

The phenomenon of speculative excess has less to do with free markets than with high profits. “When the profits of trade happen to be greater than ordinary,” Smith said, “overtrading becomes a general error.” [438] And rate of profit, Smith claimed, “is always highest in the countries that are going fastest to ruin”. [266]

The South Sea Bubble was the result of ruinous machinations by Britain’s lord treasurer, Robert Harley, Earl of Oxford, who was looking to fund the national debt. The Mississippi Scheme was started by the French regent Philippe duc d’Orléans when he gave control of the royal bank to the Scottish financier John Law, the Bernard Madoff of his day.

Law’s fellow Scots – who were more inclined to market freedoms than the English, let alone the French – had already heard Law’s plan for “establishing a bank ... which he seems to have imagined might issue paper to the amount of the whole value of all the lands in the country”. The parliament of Scotland, Smith noted, “did not think proper to adopt it”. [317]

One simple idea allows an over-trading folly to turn into a speculative disaster – whether it involves ocean commerce, land in Louisiana, stocks, bonds, tulip bulbs or home mortgages. The idea is that unlimited prosperity can be created by the unlimited expansion of credit.

Such wild flights of borrowing can be effected only with what Smith called “the Daedalian wings of paper money”. [321] To produce enough of this paper requires either a government or something the size of a government, which modern merchant banks have become. As Smith pointed out: “The government of an exclusive company of merchants, is, perhaps, the worst of all governments.” [570]

The idea that The Wealth of Nations puts forth for creating prosperity is more complex. It involves all the baffling intricacies of human liberty. Smith proposed that everyone be free – free of bondage and of political, economic and regulatory oppression (Smith’s principle of “self-interest”), free in choice of employment (Smith’s principle of “division of labour”), and free to own and exchange the products of that labour (Smith’s principle of “free trade”). “Little else is requisite to carry a state to the highest degree of opulence,” Smith told a learned society in Edinburgh (with what degree of sarcasm we can imagine), “but peace, easy taxes and a tolerable administration of justice.”

How then would Adam Smith fix the present mess? Sorry, but it is fixed already. The answer to a decline in the value of speculative assets is to pay less for them. Job done.

We could pump the banks full of our national treasure. But Smith said: “To attempt to increase the wealth of any country, either by introducing or by detaining in it an unnecessary quantity of gold and silver, is as absurd as it would be to attempt to increase the good cheer of private families, by obliging them to keep an unnecessary number of kitchen utensils.” [440]

We could send in the experts to manage our bail-out. But Smith said: “I have never known much good done by those who affect to trade for the public good.” [456]

And we could nationalise our economies. But Smith said: “The state cannot be very great of which the sovereign has leisure to carry on the trade of a wine merchant or apothecary”. [818] Or chairman of General Motors.

* Bracketed numbers in the text refer to pages in ‘The Wealth of Nations’, Glasgow Edition of the Works of Adam Smith, Oxford University Press, 1976

The writer is a contributing editor at The Weekly Standard and is the author, most recently, of On The Wealth of Nations, Books That Changed the World, published by Atlantic Books, 2007